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Social Security, Medicare, and retirement benefits: How they work

At a glance:

  • What are Social Security benefits? Here are the basics

  • Who is eligible for Social Security benefits?

  • How does you qualify for Social Security benefits?

  • Who pays Social Security and Medicare taxes?

  • How Social Security and medicare fit into retirement planning

  • The problem with Social Security

  • Summary of Social Security, medicare, and retirement

Most Americans don't start saving for retirement as early as they should. As a result, many people depend heavily on Social Security for their retirement funds. But will Social Security funds be there when you retire? How much Social Security will you need to live comfortably in retirement?

In addition to your retirement income, determining your healthcare coverage also becomes increasingly important. Americans are living longer than ever before at a time when retirement and healthcare expenses are increasing.

Today, many are concerned that Social Security and Medicare benefits won't be there when they need them. The first step toward maximizing your benefits is to understand how they work.

What are Social Security benefits? Here are the basics

Social Security benefits are not based on financial need. They are based on average lifetime earnings and the amount of time you've worked. All who pay Social Security taxes can get Social Security benefits when they retire.

By paying Social Security taxes, you are also eligible to receive disability and death benefits, in addition to Medicare benefits. However, you must earn enough Social Security credits to qualify.

Disability and Medicare, too

Besides retirement income, Social Security also pays disability benefits to those who cannot work due to physical or mental problems. These benefits are available to you at any time if you have earned enough credits. In addition, family members such as a spouse or children may be eligible for benefits in the event of your death. This is known as a survivor benefit.

In general, people over 65 who qualify for Social Security benefits also qualify for Medicare, as do those who have been getting disability for at least two years.

How it's calculated

At retirement, your monthly Social Security benefit is based on the period of your past work history in which you made the most money. Your monthly benefit comes from a formula using your average indexed monthly earnings (AIME). At present, retirees can expect to earn about 40% of their annual average lifetime earnings in Social Security benefits each year. Benefits may be adjusted each year to keep up with inflation.

Social Security benefits are progressive. People who earn less have a greater percentage of their wages returned to them through Social Security benefits than higher wage earners do.

For more information

Social Security is one of the most important programs in the fight against elderly poverty. It also provides important family protection through its death and disability benefits. The Social Security Administration (SSA) has calculators that can help you estimate your future benefits. You can find them on its Website.

The SSA resumed mailings of benefit statements at five-year intervals to workers who had not signed up to view their statements online. The statements will be sent to workers age 60 and older.

Who is eligible for Social Security benefits?

If you are like most people, you'll pay Social Security taxes throughout your career. But when can you begin to benefit from Social Security?

If you were born before 1938

If you were born before 1938, full retirement benefits are available at age 65, with reduced benefits available as early as age 62. The age at which full benefits are paid will rise in the future. In 2003, the full retirement age went up to 67 for those born in and after 1960.

If you retire before your full retirement age

The age at which you can retire and receive full benefits is known as your full retirement age. The full retirement age is 65 for people born before 1938, and 66 for those born in 1943–1954. For those born from 1955–1959, full retirement age increases from 66 and 2 months for 1955 to 66 and 10 months for 1959. Full retirement age is 67 for people born in 1960 or later.

If you choose to retire before your full retirement age, your benefits will be reduced (the reduction is currently 5/9 of 1% for every month under your full retirement age). In other words, the closer you are to full retirement age when benefits start, the smaller the reduction in benefits.

If you continue working in retirement

If you are younger than full retirement age, $1 in benefits will be deducted for each $2 in earnings you have above the annual limit ($18,240 in 2020). In the year you reach your full retirement age, your benefits will be reduced $1 for every $3 you earn over a different limit ($48,600 in 2020) until the month you reach full retirement age. Then you get your full Social Security benefit payments, no matter how much you earn.

It is important to note that the above-mentioned benefit reductions are not lost forever. Your benefit will be increased at your full retirement age to account for benefits withheld due to earlier earnings. Note, too, that if you retire later than full retirement age, you will get added benefits because of additional earnings and special credits.

Your family members and benefits

When you die, if you were eligible for either retirement or disability benefits, family members may also be able to receive benefits. Your spouse can receive up to 100 percent of your benefit amount, and your children can receive up to 75 percent of your amount.

Those who may be able to receive a benefit upon your death include the following:

  • A spouse over the age of 60 (50 if disabled or any age if taking care of children under age 16)

  • Unmarried children under 18, children in school under age 19, and disabled children 22 or younger

Getting your benefits

To get your benefits, you will need to supply proof of eligibility, such as a birth certificate and most recent W2 form.

The Social Security Administration has calculators that can help you estimate your future benefits. You can find them on its Website.

People line up outside of the Social Security Administration office in San Francisco, California. (Photo: Justin Sullivan/Getty Images)
People line up outside of the Social Security Administration office in San Francisco, California. (Photo: Justin Sullivan/Getty Images)

How does you qualify for Social Security benefits?

As you work and pay taxes, you earn credits that qualify you to receive Social Security benefits. Your wages are posted to your Social Security record, and you receive Social Security credits based on those wages.

The credits you earn remain on your Social Security record if you change jobs or don't work for a while.

How it works

Each credit gives you one quarter (three months) of coverage. Quarters of coverage are determined by your wages. The amount needed for a quarter of coverage changes each year. You can earn up to four credits each year. Most people (those born after 1929) need 40 credits (10 years of work) to qualify for benefits.

The amount you need to earn a credit tends to go up each year. The amount of credits you need to get Social Security benefits depends on your age and the type of benefit you are applying for.

Earning credits

Certain professionals earn credits at different rates than regular employees. Some of these include the following:

  • Farmers

  • Domestic workers

  • Church workers

If you are self-employed or work in the military

If you are self-employed or work in the military, you earn credits the same way as regular employees. Military workers may be able to earn extra credits. If you work for a nonprofit organization, you may be able to get benefits with fewer credits.

For more information

For complete details on credit requirements, contact the Social Security Administration.

The Social Security Administration has calculators that can help you estimate your future benefits. You can find them on its Website.

Who pays Social Security and Medicare taxes?

Who pays Social Security taxes? If you work, you do.

How the taxes work

Social Security and Medicare taxes are withheld from your paycheck, matched by your employer, and sent to the IRS. You and your employer each pay 7.65 percent of your gross earnings in taxes, up to maximum taxable earnings of $137,700 in 2020. This limit usually, but not always, increases each year. Your earnings are reported to Social Security under your Social Security number. If you are self-employed, you pay all of your Social Security taxes on your self-employment income (15.3 percent).

If you earn more than the yearly Social Security limit, you still have to pay Medicare taxes on your earnings. This rate is 1.45 percent, or 2.9 percent for self-employed workers, plus an additional 0.9% on certain higher earnings.

Trust funds hold Social Security taxes

The Social Security taxes you pay go into trust funds in the US Treasury. These trust funds are called the Old Age and Survivors Insurance (OASI) and the Disability Insurance (DI) trust funds. The OASI pays for retirement and survivors' benefits. The DI pays disability benefits.

There are also two Medicare trust funds: Hospital Insurance (HI) and Supplementary Medical Insurance (SMI). Most of your payroll taxes (6.2 of the typical 7.65 percent) go to OASI.

Money from payroll taxes is collected and deposited into the Social Security trust funds. Any money not used to pay benefits is invested in special non-marketable US government bonds. The trust funds are managed by a board of trustees and are funded by the partial reserve method. The goal of partial reserve is for the funds to take in more money than they pay out in order to prepare for increasing numbers of retirees.

How the bonds work

A bond is essentially a loan with interest — an IOU. The bond issuer (in this case the government) agrees to pay interest on the loan as well as pay back the full amount of the bond at a preset future date. The government uses the proceeds of the bonds Social Security invests in to pay for a wide array of government programs.

The Social Security trust funds earn interest on these bonds. In other words, the government borrows the money paid in Social Security taxes to use for general obligations, and issues IOUs to itself in return.

How Social Security and Medicare fit into retirement planning

As you move closer to retirement, determining your retirement income and healthcare coverage becomes increasingly important. Americans are living longer than ever before at a time when retirement and healthcare expenses are increasing.

At age 65, the typical retirement age, the average man will live until age 84, while the average woman will live until age 86, according to the Social Security Administration.

Mark Findlay and his wife Delores Findlay, of Erie, Pennsylvania, read the morning newspaper inside their home at Limetree Park where they spend the winter months in Bonita Springs, Florida, March 23, 2012. Medicare and Social Security, the massive programs that pay benefits to tens of millions of older Americans, are contentious issues in the 2012 presidential campaign. Seniors want the nation?s sputtering economy to be fixed, but not at their expense.   REUTERS/Steve Nesius  (UNITED STATES - Tags: ELECTIONS POLITICS SOCIETY)
Mark Findlay and his wife Delores Findlay, of Erie, Penn., read the morning newspaper inside their home at Limetree Park where they spend the winter months in Bonita Springs, Florida. (Photo: REUTERS/Steve Nesius)

Factoring Social Security into retirement planning

Social Security provides monthly income to retirees based on the contributions they made while they were employed. The exact amount of the monthly benefits depends on how much you earned during the years you worked and the age at which you retire. Some people who collect Social Security will have to pay income taxes on their benefits.

If you are divorced and haven't remarried, you can claim your former spouse's benefits if those benefits are higher than what you could get with your employment record. Social Security also provides coverage to spouses and widows and widowers.

Social Security benefits last as long as you live. While Social Security is an important component of retirement planning, Social Security benefits are not meant to provide enough retirement income to live on.

While most Americans born after 1938 are eligible to collect Social Security benefits beginning at age 62, in most cases, you might be better off if you wait until ages 65 or 67 because you will collect a larger benefit and ultimately receive more money over your lifespan. For example, a 54-year-old who is earning $30,000 a year with enough employment credits to qualify for benefits who plans to retire at age 62 will receive approximately $841 a month. However, if that same 54-year-old waits until age 67 to begin receiving Social Security, that benefit increases to about $1,250 per month. And it increases even more, to about $1,571, if the 54-year old waits until age 70.

To find out more about what kind of Social Security benefit you might receive at retirement, check out these Social Security calculators. You can get more information about your earnings history and how that impacts your future benefits by logging into your Social Security account online.

Medicare and retirement planning

Medicare provides health insurance coverage beginning at age 65. Medicare has four parts, including:

  • Part A: Hospital insurance that pays for hospital stays and services

  • Part B: Medical insurance that pays for doctor's visits and outpatient services

  • Part C: Medicare Advantage plans through which you can choose to receive your hospitalization and medical coverage

  • Part D: Prescription drug coverage

Nurse Katie Baker examines patient Mildred Arce at the Esperanza Health Center in Philadelphia. (Photo: DOMINICK REUTER/AFP via Getty Images)
Nurse Katie Baker examines patient Mildred Arce at the Esperanza Health Center in Philadelphia. (Photo: DOMINICK REUTER/AFP via Getty Images)

Medicare is an important component of retirement planning because healthcare costs are a rising portion of retirement budgets. While Medicare isn't free, monthly premiums, co-pays and deductibles are fairly reasonable. For more information about what Medicare is likely to cost you during retirement, check out the government's Medicare Website.

When working on a retirement budget, it is important to factor these Medicare-related costs in and to plan on some of those costs increasing over time. In addition, Medicare doesn't cover long-term care costs such as assisted living or nursing homes, although it does cover some rehabilitative services after surgeries or medical events such as a stroke.

If you are low-income

Medicare does offer some financial assistance for low-income people who don't have the ability to pay some or all of their premiums, co-pays and deductibles for hospitalization, outpatient services and even prescription drug coverage. If you meet Medicaid income levels and you are 65 or older, you may be eligible for Medicaid, which may then pay for more of your health insurance expenses, including long-term care. More information is available at the Medicare Website.

The problem with Social Security

Most Americans don't start saving for retirement as early as they need to. This leaves many people dependent on Social Security for their retirement funds.

But will Social Security funds be there when you retire?

Nearly 45 million Americans currently receive Social Security benefits, which are paid for through payroll taxes and interest from special bonds that the tax money is put into. Social Security began running into problems in 2010, when taxes alone were no longer enough to cover Social Security benefits paid out.

Interest from the bonds invested in by Social Security trust funds has enabled the funds to pay out benefits since then, and should continue to do so through 2020.

Beginning in 2021, the trust funds will need to redeem asset reserves in order to help pay out benefits, thus reducing the size of those reserves over time until they run out of money in 2035.

The Social Security Board of Trustees predicts that by 2035, Social Security will be able to cover only about 75 percent of all benefits. These benefits will be covered by the payroll taxes that the Social Security Administration continues to collect from workers' paychecks. The reserves in the trust funds will be gone.

If you are retiring within the next fifteen or so years, your benefits will probably be fully covered.

How to remedy these problems?

Many factors will decide whether these predictions come true. More people in the workforce and a stronger economy could lessen the problem. Possible solutions to the Social Security problem include privatizing Social Security, raising payroll taxes, increasing the retirement age, changing the 35-year earnings average to 38 years, and allowing Social Security trust funds to be invested in the stock market.

A summary of the Social Security trustee report can be found here.

Summary of Social Security benefits

Social Security and Medicare were designed to be a safety net, not a full retirement plan and health plan. Yet many persons act as if that's just what they are. Unfortunately, the system cannot work that way.

It is still up to individuals to take personal responsibility for planning for their retirement, with Social Security and Medicare retirement benefits as two of the sources of retirement funding.

Practical ideas you can start with today

  • Estimate your expected Social Security benefits.

  • Use the planner on the Social Security Website to help map your retirement.

  • Visit www.medicare.gov to learn the details of traditional Medicare, Medicare Advantage, and Medicare supplement insurance.

  • Be aware of upcoming enrollment periods if you are nearing the age of 65.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

Read more information and tips in our Retirement planning section

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