This article was first posted January 1, 2013.
I was looking at my annual Social Security statement last month and played around with the Social Security calculator you can download from the SSA site.
The last few years I've been getting about $9,000/yr of royalty income on some engineering materials I authored years ago. While there is currently a 2% cut in payroll taxes for 2012, the usual self-employed FICA rate is 15.3% (10.6% for Social Security, 1.8% for Disabilty Insurance, and 2.9% for Medicare Hospital Insurance.) That means I'll pay $954 in FICA taxes towards Social Security. If I keep getting $9,000/yr in earnings until I turn age 62, I will have paid $4,770 in FICA Social Security taxes over 5 years. Adjusting for the time value of money at the 5-year Treasury rate of 0.77% increases that $4,770 to $4,844.
Is Social Security a good deal?
Looking at the difference in the monthly benefit between CASE 3 and CASE 4 in the table below, you'll see that those 5 years of $9,000 annual FICA earnings and a total payment of of $4,844 in FICA taxes increased the monthly Social Security benefit by $26/month. Let's compare this to the cost of purchasing an inflation-adjusted life annuity from an insurance company.
At current rates, a $100,000 premium would buy a 62-year-old about a $350/month benefit from an insurer with a high rating. That calculates to about $17/month for a $4,844 premium. The Social Security benefit I "bought" for $4,844 in FICA taxes is more than 50% higher than what an insurance company would offer.
Of course, my situation is a bit different than most. Since I quit work in 1994 at age 38 after I'd accumulated enough in savings to retire, I have a lot of zeros on my Social Security earnings record. If you retired at age 57 after a career where you'd paid the maximum FICA tax throughout, you'd likely get no increase in your benefit from an additional 5 years of $9,000/yr in income subject to FICA taxes. (See CASE 1 and CASE 2 below.) This is because your Social Security benefit is based on your highest 35 years of indexed earnings.
Why is Social Security a good deal for me and a bad one for you?
There are two bend points in the Social Security formula for calculating your monthly benefit. For 2012, you get a 90% credit for your first $749 in average indexed monthly earnings (AIME) subject to FICA, a 32% credit for AIME between $749 and $4,517 per month, and a 15% credit for everything over $4,517. Someone who paid the maximum FICA tax for the past 35 years and retired in 2012 at age 62 would have average indexed monthly earnings of a bit more than $8,000. To keep your benefit within the second bend point where you get a 32% credit on your earnings, your FICA wages would have to average about 57% of the maximum FICA wage over the past 35 years. To stay within the first bend point where you get a 90% credit, you'd have to earn less than 10% of the maximum FICA wage over 35 years -- a near-poverty level wage.
Of course, instead of working for a poverty wage for 35 years to stay within the first bend point, you could have five or six years at the maximum FICA wage and then average in 25 or 30 years of zeros, that is, retire a lot earlier. The table below illustrates this result using the scenario where the individual retires, and then gets 5 years of $9,000/yr of FICA income from age 57 until age 62. That 5 years of income and the payment of $4,844 in FICA tax nets the 57-year-old retiree only an additional $12/month in his Social Security check. Retire ten years earlier at age 47 to stay within the second bend point, and that $4,844 in FICA tax buys you an extra $27/month in benefits. Quit work at 30, and the $4,844 in FICA boosts your Social Security check by $76/month -- almost 4-1/2 times the benefit an insurance company would provide with an annuity.
Do high income Social Security recipients get hosed?
If you paid the maximum FICA tax over the past 35-years, and retired at age 62 in 2012, you would have paid $114,813 in Social Security FICA, $17,459 in Disability Insurance, and $36,099 in Medicare Hospital Insurance for a total of $168,371. Your employer matched those contributions, so the Social Security total comes to $229,626 and the overall FICA total is $336,742. You would be entitled to a monthly Social Security benefit of $1,881.
An insurance company would charge a 62-year-old male about $537,000 for an inflation-adjusted life annuity of $1,881/month. (A 62-year-old female would pay about $580,000 for the same benefit.) That's a lot more than the $229,626 you and your employer paid in Social Security FICA over the past 35 years, but we haven't factored in a rate of return on your money. If you got a 10% annualized return over the last 35 years on that $229,626 in taxes, you'd have a bit more than $600,000. (See spreadsheet.) Of course, most people fall far short of a 10% long-term return. Invesment firm DALBAR calculated that the average investor earned 2.1% annualized for the 20-year period ending Dec 31, 2011, leaving him far short of the $537,000 required to buy an annuity. (At a 2.1% annualized return, your $229,626 in taxes only grows to $307,000.) Whether or not Social Security is a good deal for high income earners depends on their investing luck and skill.
If you want to learn more about the Social Security Administration calculates your monthly benefit, this article from the Journal of Financial Planning is a good place to start.