What is Social Security and How Does It Work?

When you look at your paycheck stub, you notice taxes for Social Security, but what is it and how does it work?

The concept of Social Security is easy enough. It’s a benefits program from the federal government aimed at provided supplemental income to American retirees.

But how it works can be a little more complex.

There are a lot of moving parts to Social Security and a lot of different layers to the program.

That’s why Money and Markets set out to answer this question for our readers: What is Social Security and how does it work?

We’ll take a look at the history of Social Security, the details of how it works, the many different layers, how you can apply for benefits and the troubled future of the program.

The History of Social Security

While President Franklin D. Roosevelt officially started the Social Security program in 1935, its roots in the U.S. go back to 1776.

The Founding Fathers passed a national pension program for soldiers in 1776 — even before the Declaration of Independence was signed.

But it wasn’t until after the Civil War that a pension system came into full focus.

In 1862, Congress passed the first legislation starting a pension program for soldiers. It provided benefits linked to disabilities “incurred as a direct consequence of … military duty.” It included that widows and orphans could receive pensions equal to what their deceased family member would have received if he were disabled.

By 1910, all Civil War veterans received benefits under the program after Congress made it possible with legislation in 1890 and 1902.

According to the Social Security Administration, there were still descendents of Civil War veterans getting Civil War pensions as late as 1999.

But it wasn’t until the Great Depression of the 1930s that a program to help give financial security to citizens started to take shape.

Before Roosevelt marshaled through today’s Social Security plan, there were others who suggested ways to improve financial solvency, specifically for the working poor. Louisiana Sen. Huey Long proposed the federal government guarantee a $5,000-a-year income for all families in 1930.

California doctor Francis E. Townsend suggested a plan where people over the age of 60 get a pension of $200 a month in 1933. Novelist Upton Sinclair proposed a plan for a $50-a-month pension for people over the age of 60 in California in 1934.

A form of social insurance was enacted in European countries, starting with Germany in 1889.

Finally, in 1934, Roosevelt proposed the modern-day Social Security program in a speech to Congress. In 1935, following a report from the Committee of Economic Security.

In the original act, benefits would be paid to only primary workers when they retired at age 65. Those benefits were based on payroll tax contributions the worker made during their working life.

Initially, Congress filibustered the budget bill for the Social Security Act and the Social Security Board had to borrow money to operate until January 1936, when Congress finally passed a budget bill for Social Security.

After the act was passed by Congress, taxes were first collected in 1937 and payments were to begin in 1942 (however, future legislation moved the payout start to 1940).

Once those taxes were collected, they were placed in Social Security trust funds, and funds were dispersed from those trust funds.

The earliest recorded applicant for benefits was a Cleveland motorman who retired a day after the program began. His lump-sum payment amounted to $0.17.

Understanding this history goes a long way to answering the question of what is Social Security?

How Social Security Works

The concept of Social Security is simple. You pay money to a system that pays you back some money when you retire.

So your earnings made while you work go into a trust fund, and when you retire, those benefits are paid back to you as retirement income. If you don’t work — meaning if you don’t pay taxes — you don’t get benefits.

You are issued a Social Security number that links to your earnings while you are working and your benefits when you start receiving them.

But Social Security was never meant to be the sole source of income for retirees. It is supposed to replace a percentage of pre-retirement income based on those earnings.

Benefits have expanded beyond just for those who worked. Others who can receive benefits include:

Disabled
A spouse or child of someone getting benefits
A divorced spouse of someone getting or eligible for Social Security
A spouse or child of a worker who died
A divorced spouse of a worker who died
A dependent parent of a worker who died

Your circumstances could determine receiving benefits at any age. According to the Social Security Administration, Social Security pays more benefits to children than any other government program.

In 2020, $0.85 of every Social Security tax dollar you pay goes into a trust fund that pays monthly benefits to current retirees and their families. The other $0.15 goes to a trust fund that pays benefits to people with disabilities and their families.

You pay Medicare taxes on all your wages. Those taxes are set aside for Medicare health insurance coverage you use when you retire.

Currently, if you are working for someone else, you are taxed 6.2% for Social Security and 1.45% for Medicare. Your employer pays the same amount. If you are self-employed, you pay the full 12.4% for Social Security and the full 2.9% for Medicare.

Eligibility for Social Security benefits is based on a credit system. You earn one credit for every $1,410 in earnings. Most need 40 credits to qualify for benefits.

However, you can only collect benefits once you reach a certain age. If you were born between 1943 and 1960, you can collect retirement benefits at 66. After 1960, the full retirement age is 67.

Of course, you can choose to delay receiving benefits to after age 67 and they will actually increase. Basically, the longer you wait to take benefits, the more you can earn from Social Security — but you’ll have less years to spend your earnings.

On the other end of that, you can actually start taking retirement benefits at age 62, but those benefits are considerably less. Your benefits reduce by 0.5% for each month you receive them before you are eligible.

For example, if your full retirement age is 66 and you sign up for Social Security benefits at age 62, you will only receive less than 70% of your full benefit.

You can also work and still receive retirement benefits. Your benefits won’t decrease despite how much you earn after you reach full retirement age.

Disability and Other Benefits Under Social Security

Another part of the Social Security program is Social Security Disability Insurance and Supplemental Security Income.

If you don’t work because of a physical or mental condition lasting at least one year or resulting in death, you may be eligible for disability benefits.

The process for receiving disability benefits is quite rigorous and can take much longer than qualifying for other programs.

In order to qualify, you first have to have worked in jobs covered by Social Security. You then have to have a medical condition covered by the Social Security definition of disability.

If you meet all the stipulations, you can receive monthly benefits from Social Security, including health care coverage.

There are provisions for those who are considered blind or have low vision. The rules are a little different, but there are special benefits available for those who meet the criteria.

There are also disability benefits available for disabled widows, widowers or surviving divorced spouses of workers. The same disability criteria have to be met for widows, widowers and surviving divorced spouses as workers.

Supplemental Security Income (SSI) can be added to your Social Security benefits if you have limited income and resources. Your house and your car do not count as resources when determining eligibility and total benefit payment.

SSI benefits are drawn from general government revenues, not Social Security taxes. It makes payments to those 65 and older or who are blind or disabled.

Understanding disability benefits helps answer the question of what is social security?

Medicare — Health Insurance

Simply put, Medicare is health insurance for people 65 and older, or those with disabilities.

If you are drawing Social Security benefits you also likely qualify for Medicare. However, there are four different parts of Medicare coverage:

Medicare Part A (hospital insurance) helps pay for inpatient care in a hospital or limited time at a skilled nursing facility (following a hospital stay). Part A also pays for some home health care and hospice care.
Medicare Part B (medical insurance) helps pay for services from doctors and other health care providers, outpatient care, home health care, durable medical equipment, and some preventive services.
Medicare Advantage Plan (previously known as Part C) includes all benefits and services covered under Part A and Part B — prescription drugs and additional benefits such as vision, hearing and dental — bundled together in one plan.
Medicare Part D (Medicare prescription drug coverage) helps cover the cost of prescription drugs.

Part A benefits are automatic if you are eligible for Social Security or Railroad Retirement Board benefits. You can also qualify based on your spouse’s work. Government employees who are not covered by Social Security — but pay the Medicare tax — are also eligible.

If you are eligible for Part A, you are typically eligible for Part B. The difference is Part B is supplemental insurance and you have to pay a monthly premium. In 2020, that premium is $144.60 monthly.

Medicare Advantage plans can also be joined if you have Part A and Part B. Advantage plans may come with a monthly premium as well. Those plans include:

Health Maintenance Organization (HMO) plans
Preferred Provider Organization (PPO) plans
Private Fee-for-Service (PFFS) plans
Special Needs Plans (SNPs)

Part D is Medicare prescription drug coverage. There is an extra monthly premium for the coverage but if you have Part A or Part B, you are eligible. If you have Medicare Advantage, you can also get the plan unless you have a private-fee-for-service plan. Part D can also be a standalone plan if you wish.

Because it’s an integral part of the program, understanding Medicare helps answer the question of what is Social Security?

How to Apply for Social Security

There are several ways to apply for Social Security benefits. You can apply online, by phone or in person at your local Social Security office.

If you live outside the U.S., you can reach out to the Federal Benefits Unit that provides service to your country of residence.

Here are some of the criteria you must meet when you apply:

You must be at least 61 years and 9 months old to apply for retirement benefits.
If you are already age 62, you may be able to start your benefits in the month you apply.
You should apply for benefits no more than four months before the date you want your benefits to start.
Benefits are paid the month after they are due. If your benefits start in April, you will receive your first benefit payment in May.
If you are not getting Social Security and you are not ready to retire, you should still use our online retirement benefit application to sign up for just Medicare three months before your 65th birthday.

You also need to make sure you have the right information when you apply. Here are links to what you need:

You may be asked to provide other documentation such as bank information, a birth certificate or other information.

The Future of Social Security

According to the Social Security Administration, the funds to pay out benefits in full will last until 2037 (but this report says it’s closer to 2035) — when the trust fund reserves run out.

But that doesn’t mean you won’t get benefits after 2037.

Continuing taxes will fund approximately 76% of benefits after that.

It means Congress will have to make significant changes to the tax structure and other revenue in order to make the program more solvent.

The Social Security Board of Trustees said benefits would have to be cut by 13%, or increase the combined payroll tax to 14.4% from its current level of 12.4%.

There are two trust funds that pay for Social Security benefits — Old-Age and Survivor Insurance (OASI) fund and the Disability Insurance (DI) fund. In order to pay out full benefits, both funds have to be solvent.

These funds don’t have the ability to borrow money to fund payouts, so they are dependent only on the taxes deposited in them.

Those funds had $2.8 trillion in reserves at the end of 2018, but payments going out are cutting deeper into those reserves because of a higher number of retirees, coupled with lower birth rates. Basically, the baby boomer generation is quite large and retiring now, while fewer people have been born so fewer people work and pay into the trust funds.

Because of the limitations to revenue, to make the funds more solvent taxes have to be raised or benefits would have to be cut. According to AARP, other proposals — and their benefits — being considered include:

Raising the retirement age — Congress has considered raising the full retirement age to 68 or even 70. Essentially, it would take longer to draw Social Security benefits. This would help fill approximately 44% of the funding gap.
Indexing retirement — Otherwise known as longevity indexing, this would modify Social Security to pay smaller monthly benefits as lifespans increase. This would help fill between 20% and 26% of the funding gap.
Recalculate the cost of living adjustment — Because benefits include a cost of living adjustment, based on the consumer price index, adjusting it with different formulas could fix between 16% and 23% of the funding gap.
Increase the payroll tax cap — Currently, the payroll tax cap for Social Security is $110,100. Earnings over that are not subject to the Social Security tax. Raising the tax cap by 90% to around $215,000 would fill 36% of the funding gap.
Eliminate the payroll tax cap — This would apply the Social Security tax to any income, no matter how much. Doing so would fill 86% of the funding gap.
Reduce benefits for higher earners — Other proposals include reducing the benefits for either the top 25% or top 50% of earners by 15% or 28%. This would fill between 7% and 31% of the funding gap.
Increase the payroll tax rate — Currently, Social Security takes out 6.2% in taxes on income up to $110,100. Proposals include increasing that to 6.45% for both employees and employers, which would fill 22% of the funding gap. Another proposal is to gradually increase the tax to 7.2% over 20 years — filling 64% of the funding gap.
Salary reduction plan taxes — Payroll taxes for Social Security are collected on things like 401(k) plans. They are not collected on other plans, like Flexible Spending Accounts. Taxing those would fill around 10% of the funding gap.
Cover all state and local government workers — Currently, about 25% of state and local government employees are not covered by Social Security. Bringing them all into the fold would fill around 8% of the funding gap.
Increase years used to calculate benefits — Average earnings used to calculate Social Security benefits are based on a worker’s highest 35 years of annual indexed earnings. Increasing that to 38 years would help fill 13% of the funding gap.
Means-testing Social Security benefits — Using means-testing would essentially reduce the benefits for higher-income recipients and even eliminate benefits completely for some. Implementing means-testing could fill 11% of the funding gap.

As you can see, there is no simple solution that completely solves the Social Security funding issue.

But understanding the future of the program helps answer the question of what is Social Security?

As you can see, there are a lot of components related to the country’s most important social safety net.

From its roots to its future, Social Security has become ingrained in our society and will be for years to come.

That’s why it’s important to understand what is Social Security and how it works.

Here are some quick facts surrounding Social Security, according to the Social Security Administration:

2020 Social Security taxes

You pay 6.2 percent and your employer pays 6.2%.
If you’re self-employed, you pay 12.4%.
You don’t pay Social Security taxes on earnings greater than $137,700.

2020 Medicare taxes

You and your employer each pay 1.45%.
If you’re self-employed, you pay 2.9 percent.
Medicare taxes are paid on all of your earnings; there is no limit.
There are additional Medicare taxes for higher-income workers.

Work credits in 2020

For each $1,410 you earn, you receive one Social Security “credit,” up to four per year.
Most people need 40 credits to be eligible for retirement benefits.
Younger people need fewer credits to qualify for disability benefits or for their family members to be eligible for survivor’s benefits.

Average estimated 2020 monthly Social Security benefits