Personal Finance

How Does Social Security Work?

Imagine living somewhere where you're 100% responsible for your own economic security, regardless of your age or health, with no one to bail you out if you find yourself in need of financial assistance. If you're a U.S. citizen, you don't have to worry about it. Through a little program called Social Security, the U.S. government has committed to providing for the economic security of its citizens.

There's a good deal of confusion surrounding Social Security and how this vast program works, so let's go over the basics that every American should know.

How does Social Security work?

Social Security works by pooling mandatory contributions from workers into a large pot and then paying out benefits to those who are eligible for them. When you work, you pay into the system by having a portion of your earnings taxed and earmarked for Social Security. For 2015, the maximum taxable earnings limit is $118,500. Later on, when you become eligible for benefits, you get to collect them instead of paying for the benefits of others.

The Social Security Administration reports that $0.85 of every Social Security tax dollar goes to a trust fund that pays monthly benefits to retirees and their families, as well as the surviving spouses or children of eligible recipients who have died. The remaining $0.15 goes toward benefits for people with disabilities and their families.

Who can collect Social Security?

You can collect Social Security once you reach a certain age or become disabled (note: the SSA has a strict definition of "disability," and benefit applicants must go through a rigorous disability determination process). You may also be able to collect survivor benefits if you're the spouse or child of a recipient who has passed away.

In order to be eligible for Social Security benefits, you must earn enough "credits" during your working years. In 2015, you'll receive one credit for every $1,220 in earnings, up to a maximum of four credits per year. These credits will count toward your future eligibility even if you switch jobs or take a break from the workforce. The dollar amount needed to earn one credit is usually raised annually. If you were born in 1929 or later, you need 40 credits, or 10 years of work, to qualify for retirement benefits. You typically need fewer credits to obtain disability benefits.

If you're eligible for survivor benefits, then you'll receive a percentage of the original beneficiary's Social Security benefit. The amount typically falls into the 75% to 100% range.

When to claim your Social Security benefits

I can hear what some of you are thinking: "I can work 10 years and get benefits? Sign me up."

Not so fast.

Even if you've accumulated your 40 credits, you can't start claiming retirement benefits until you're aged 62 or older, and the longer you wait to start collecting those benefits, the bigger the payout will be. If you wait to claim Social Security until you reach your "full retirement age" -- which is determined by the SSA and is 67 if you were born in 1960 or later -- then you'll receive your "primary benefit amount," which is the full monthly benefit you're entitled to based on your earnings record.

The earlier you claim your Social Security benefits, the lower your monthly payment will be. For example, if your full retirement age is 67 and you opt to claim benefits at age 62, then you'll get just 70% of your primary insurance amount. If you begin collecting at 65, you'll get 86.7% of your monthly benefit. On the flip side, you can earn delayed-retirement credits for waiting past your full retirement age. For every extra year you wait to claim Social Security benefits, your eventual payout will increase by 8%. Your benefits max out at age 70, though, so there's no reason to delay benefits beyond that point.

If you're receiving Social Security disability benefits at the time you reach your full retirement age, then your disability benefits will automatically convert to retirement benefits, but the amount won't change.

How much will I get?

Your Social Security retirement benefits will depend on how much money you earned during your working years and your age at the time you start collecting benefits. Similarly, your Social Security disability benefits are based on your eligible lifetime average earnings.

The Social Security Administration sends out annual benefit statements, and yours should include an estimate of how much money you'll get once you reach your full retirement age. You can also use the Social Security online benefits calculator to estimate your monthly benefits. Keep in mind that the younger you are, the less accurate your estimate is likely to be, since your future earnings could affect your overall payout.

Will I be able to live off my Social Security benefits?

Your Social Security benefits are only designed to replace about 40% of your pre-retirement income. Most financial experts say you'll need about 70% of your pre-retirement income to live comfortably in retirement, so you have to take steps to bridge that 30% gap (or an even larger gap if you'd like to live in style). That means you'll need to create dependable streams of retirement income. These can include savings in a 401(k) or IRA, annuities, and more.

Will Social Security even be around by the time I retire?

According to the Social Security Administration's 2015 report, the combined funds used to pay retirement and disability benefits are likely to be depleted by 2034.

But that doesn't mean all is lost.

The report also states that once those funds are gone, ongoing taxes should be sufficient to pay 79% of scheduled benefits in 2034 and 73% in 2089. Still, with the future of Social Security on relatively shaky ground, if you're nowhere close to retirement at this point, your best bet is to take matters into your own hands. Save aggressively, invest wisely, and think of your Social Security benefits as an added bonus. This way, you're less likely to be thrown for a financial loop if they don't end up coming through.

The $15,978 Social Security bonus most retirees completely overlook

If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. In fact, one MarketWatch reporter argues that if more Americans knew about this, the government would have to shell out an extra $10 billion annually. For example: one easy, 17-minute trick could pay you as much as $15,978 more... each year! Once you learn how to take advantage of all these loopholes, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how you can take advantage of these strategies.

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