Can Taxing the Wealthy Save Social Security?

Social Security Changes For 2016/2017 Must Watch

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According to the most recent annual report from Social Security"s Trustees, the Old Age and Survivors Insurance (OASI) Trust Fund is set to exhaust itself some time in 2034. Once we hit that barrier, the program won"t disappear entirely, but benefits will likely need to be reduced by 25%.

That might sound like a modest cut, but it"s important to consider that for 22% of retired married couples -- and 47% of retired singles -- Social Security accounts for an astounding 90% or more of household income. Such cuts could mean serious sacrifices for future generations.

There are lots of suggestions on the table to remedy the situation. Over the past month, I"ve evaluated the effectiveness for some of the most popular options from both Republicans and Democrats. Today, I"m zeroing in on the one solution that has the greatest demonstrated leverage: raising taxes on the wealthy.

How much more would wealthy households have to pay in new Social Security taxes?

Under its current structure, every working individual pays in to Social Security via FICA taxes. An employee is responsible for forking over 6.2% of his/her salary to the program, while their employer is obligated to pay an equal amount.

However, there are maximum limits on taxable income -- often dubbed the "tax max." In 2016, the tax max is $118,500. In other words, at this income level, an individual will owe about $7,350 in taxes to support Social Security. But an individual who makes $200,000 will only owe $7,350 as well. So will someone earning $2 million. The tax simply stops being applied after the tax max.

If the tax max were eliminated, the individual earning $200,000 would owe $5,050 more than they currently do. And the household with $2 million would owe a whopping $117,000 more. That"s not chump change -- for the household or Social Security in general.

Would eliminating the tax max actually make a difference?

Proponents of eliminating the tax max point out that by doing so, a huge swath of Social Security"s shortfall could be addressed. According to the American Association of Actuaries, eliminating the tax max would address 88% of the program"s long-term deficit.

In other words, this alone wouldn"t solve Social Security"s problems, but it would take a huge bite out of it.

There are, however, a number of second-order effects that opponents of the move are worried about. A 2014 report from the Heritage Foundation laid out the reasoning as such:

Higher-income workers generally have more flexibility to work less when marginal tax rates rise. But when workers cut back on work and receive less take-home pay, they also tend to cut back on savings and investment. Less work, lower incomes, smaller savings, and less investment are harmful to economic growth, which in turn, is detrimental to tax revenues.

Is there a precedent for raising the tax max?

For much of Social Security"s history, the tax max was updated on an ad-hoc basis. Starting in 1975, increases were made yearly, based on average increases in wages. Here"s what those increases look like, in both real dollars, and inflation-adjusted dollars.

Eliminating the tax max would be dramatic in a historical sense. President Obama proposed a plan where families would avoid Social Security taxes for all the money they earn between the tax max ($118,500 in 2016) and $250,000, and then start paying taxes again once that threshold is breached. No serious action, however, was ever taken based on the proposal.

If Social Security"s shortfall is ever truly dealt with by politicians, it is likely that a substantial increase in the tax max would be coupled with other changes -- probably aimed at reducing benefits. The most popular tends to be a gradual increase in the full retirement age.

There"s no way to predict what will happen with the program. But it"s clear that the most important thing you can do to prepare for retirement is to assume that your benefits will be reduced by 25% at least. If that motivates you to save and invest more now, it"ll only be beneficial in the long run.

Source: http://www.fool.com/retirement/2016/07/11/can-taxing-the-wealthy-save-social-security.aspx