It is that time of year when you realize just how much you pay in taxes. [ Food for thought: Did the IRS intentionally put the due date for taxes opposite from elections in November? ] But this is also the time of year you likely received a letter or email from the Social Security Administration letting you know what you are likely to get in retirement.
Being blessed with a skill set that is currently highly valued and paid, I do not take it for granted and realize there could be a repeat of the “dot-bomb” that left a lot of engineers without a job. Which is one of the many reasons I choose to live debt free. Many people do not realize that just how much Social Security costs, not just as a percentage of your income today, but also in how inefficient and wasteful the program is.
The IRS gives a breakdown here: https://www.irs.gov/taxtopics/tc751.html But simply put, it is 12.4%. There is Medicare on top of that for another 2.9% and if you are skilled enough to earn more money, you are penalized an additional 0.9% on earnings over $200k. I will ignore this tax and focus on the true cost of that 12.4%. Just so people realize, the 12.4% is only on the first $118,500/year of earnings (as of 2016, but it increases a bit each year). That means the max tax is $14,694 for 2016.
The majority of people are employees for another company and do not realize the tax is that much because their employer is forced to pay half of it. Which means they pay you less so they can afford to pay those taxes on your behalf. You may not factor it into your salary, but I guarantee your employer does in their budget. If you decide to take the risk, start your own small company, you will be responsible for that other half.
To demonstrate the costs I will use myself as an example. Currently I make an above average salary, but this has only come in the more recent years as I have gained experience and the skill set to achieve that. Having always been an employee of a company, my employers have been paying half. As of the end of 2015, age 34, having started working when I was 16 for minimum wage at that time, there has been a total of $94,221 paid into social security by or on my behalf.
I have been working for 19 years, which means on average, my tax burden has been just under $5k/year. Less when I was younger and more now of course. To simplify the math, I will assume all of it was instantaneous this year instead of in the past. Doing this eliminates a lot of compound interest that would have/could have been accumulated over the nearly 2 decade period and makes all the numbers and differentials very conservative.
Lets take an imaginary world scenario that allows me to elect to keep 1/4th in exchange for never drawing from the government. That means I have about $23.5k to invest now and the government gets to keep the other $70k+ I have already paid in. I also get to keep 1/4th of what the SSA assumes they will collect from me to get their numbers, which is 1/4th of $14k, $3500/year
A simple compound interest calculator can tell you that. I have 33 years until I am 67 (full retirement age) and might be able to collect my social security money. I function under the assumption that they will deny me social security completely though assuming I will be disqualified for having assets, an IRA, and other investments. Even the Social Security Administration’s web site says they will likely change the laws, my assumption is that they will take more and give less in order to compensate.
Now, the rate of return to expect is always controversial, but for this calculation I have to choose something. I believe that a 7% return is a conservative number to calculate with that should keep most trolls under control and if anything, make my argument even more valid if you believe you can earn more than that. I understand that inflation averages 3.22% and other articles claim a 7% return being reasonable. I believe you can earn more than this if you invest in other things beyond just stocks and mutual funds, such as real estate, but I will stick with 7%.
I used MoneyChimp.com‘s compound interest calculator to calculate that $23.5k and $3500/year would turn into a little over $665k. Which, if I stuck it under all under my mattress at that point, I could spend ~$1850/month for the next 30 years (until I was 97 years old).
Obviously, I would invest it somewhere else besides my mattress and will assume a 7% return still, I can draw about 5%/year from it and allow the other 2% to be there to help keep up with inflation. 5% of $665k… $33,250/year… or $2,770/month. Which, is extremely close to the $2,852/month the SSA estimates for me. But the HUGE difference… I still have $665k to leave to my family as opposed to with the SSA, there is nothing for my family afterwards.
So how bad is Social Security? How much would change if I was able to keep and invest for the previous 19 years of my working life? What if I can do better than than a 7%? What if I changed my calculation to consume the principle instead of only living on the interest? How small of an amount would I need to have kept to have a better return?