Social Security as an investment

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The Social Security portion of payroll tax has a similar character to an investment. Payments are made during working years, in exchange for an income stream once retired, and other benefits. In this page, the behavior of Social Security as an investment is examined.

In the United States, Social Security tax is a component of payroll tax. Taxpayers pay 6.2% Social Security tax on all earned income, up to the maximum Social Security Wage Base ($160,200 in 2023). In addition, taxpayers pay 1.45% Medicare tax on all earned income, with no limit. There is also the Additional Medicare Tax on earned income above $200,000 for single taxpayers or $250,000 for married couples, implemented by the Affordable Care Act (ACA). Employers must deduct these taxes from their employees' payroll, and also must pay an equal amount of the Social Security and Medicare taxes (but not the Additional Medicare Tax) on wages they pay. When the taxpayer acts as their own employer (eg. as a sole proprietor or owner of a corporation), they must pay both halves, with the employer's half being tax-deductible as a business expense.

Upon reaching retirement age, the taxpayer receives monthly Social Security benefit payments based on the amount of Social Security taxes paid during working years. The investment behavior of Social Security can be examined by analyzing the relationship between the taxes paid and the benefits received.

Option to pay payroll tax
For most taxpayers, there are no legal ways to avoid payroll taxes. Payroll taxes must be paid on all earned income, so this page will have only an academic interest. However, there are two common scenarios when taxpayers have some control over payroll tax:


 * Owners of corporations may decide to split their compensation partly as wages and partly as dividends from the business, reducing payroll taxes because they are not assessed on the dividends. This split is subject to the IRS requirement for "reasonable compensation."
 * Investors contributing to a Health Savings Account (HSA) may choose to pay through a payroll deduction, avoiding payroll tax, or directly to the HSA custodian. Note: Deducting HSA contributions through an employer vs. directly on a personal tax return can have other tax impacts, such as Earned Income Tax Credit (EITC) and Expected Family Contributions.

Rate of return
The internal rate of return for Social Security benefits is calculated below for a variety of situations. Social Security benefits are calculated based on the sum of the taxpayer's top 35 years of earnings, adjusted for inflation and capped at the Social Security wage base each year. The sum, divided by 420 (35 years x 12 months) is the taxpayer's Average Indexed Monthly Earnings (AIME). The taxpayer's Primary Insurance Amount (PIA), their monthly retirement benefit when filing at Full Retirement Age (FRA), is calculated based on AIME using a progressive formula. AIME up to the first bend point, $1,115 in 2023, contributes 90% to PIA. AIME from this value up to the second bend point, $6,721 in 2023, contributes 32% to PIA. AIME beyond the second bend point contributes 15% to PIA. The three "brackets" of Social Security benefits are summarized in the following table:

The taxpayer's Social Security bracket is the primary factor affecting the rate of return. Other factors include:


 * Gender - Social Security benefits are unisex, but women live longer than men on average, and so expect to receive a larger benefit and therefore higher rate of return. However, gender doesn't affect return when married to an opposite-sex spouse, because the surviving spouse will inherit the larger payment.
 * Health - Likewise, individual taxpayers with longer life expectancy based on their health can expect a higher rate of return.
 * Income taxes - Half of payroll taxes are income tax-deductible, and future benefits may be taxable, so current and future tax rates affect rate of return.
 * Whether a spouse will be receiving benefits based on the taxpayer's earnings record. If so, the rate of return will be higher.
 * Whether one or both halves of payroll tax are paid by the taxpayer. The rate of return for paying only one half is higher. However, in practice, this is usually bad for a taxpayer making a decision whether to payroll tax-deduct HSA contributions, because the future benefit is being foregone for only half of the tax savings today.
 * Time - Payroll tax payments when older have the benefits return sooner, and so tend to have a higher magnitude of rate of return (ie. positive rates of return will be higher, negative rates will be more negative). In addition, a person's life expectancy naturally increases as they get older, because they have survived more potential causes of death. This effect improves the rate of return for older taxpayers, and can turn negative rates of return positive.

Figures 1 to 4 show charts for four potential combinations of cases, of taxpayers paying either the employee half or both halves of payroll tax, and with or without the spouse receiving a 50% benefit.

Assumptions for these charts:
 * Both Social Security and Medicare taxes are included, because both have to be paid to get an AIME credit (but the Additional Medicare Tax is excluded)
 * Income tax rates at tax payment are 10%, 12%, and 24% respectively for 90%, 32%, and 15% brackets
 * Full Retirement Age (FRA) is 67 for both the taxpayer and spouse
 * Taxpayer and spouse are the same age, opposite-sex, and file for benefits at FRA, receiving 100% and 50% respectively of the taxpayer's PIA. Note: the "no spouse" cases also apply to married taxpayers whose spouses will collect benefits based on their own earnings records.
 * Retirement benefits are untaxed for 90% and 32% brackets, but are taxed at the maximum 85% rate in the 24% income tax bracket (for a marginal tax rate of 20.4%) for the 15% bracket
 * Life expectancy is per the 2019 Social Security Administration actuarial life table, which is an average life expectancy for all Americans
 * Windfall Elimination Provision (WEP) and Government Pension Offset (GPO) do not apply
 * Only retirement benefits are considered, not disability or survivor benefits

Payback rate
The payback rate is an alternative measure of the performance, defined as the ratio of the Net Present Value (NPV) of future payments to the payroll tax cost today. It gives an idea of whether the tax payments have more of a character of an investment (payback rate of ~100% or greater) or an ordinary tax (payback rate close to 0). The payback rate is calculated for two discount rates.

In all cases, the payback rate increases with the age of the taxpayer, because life expectancy increases with age, and also because of the time value of money (for cases where the discount rate is greater than 0).

Situations when payroll tax provides no return on investment
In the following situations, paying additional Social Security tax provides no direct benefit to the taxpayer, and the payments can be considered an ordinary tax, to be avoided where possible:


 * The taxpayer will not accumulate 40 work credits (equivalent to 10 years of earnings) necessary to qualify for Social Security retirement benefits
 * The taxpayer has worked (or will work) more than 35 years, and the current year will not be one of the highest 35 years of earnings (indexed for inflation)
 * The taxpayer's personal Social Security benefit will be smaller than 50% of their spouse's benefit (except for a small potential benefit if filing before their spouse)

In addition, all payroll tax payments above the Social Security wage base, comprised of only Medicare taxes, also provide no direct benefit to the taxpayer.

Comparison to traditional investments
Social Security is most closely analogous to a deferred annuity. Compared to traditional investments, Social Security has some important advantages and disadvantages. Separate from the rate of return, advantages include:


 * Tax payments represent "forced saving" of enough of one's income to provide a basic standard of living once one can't or doesn't want to continue to work, regardless of diligence with budgeting
 * Benefits have no risks of investment loss or underperformance
 * Benefits grow tax-deferred
 * Benefits are automatically indexed to inflation
 * Benefits are automatically annuitized, protecting recipients from spending at too high a rate, and (to some degree) from other poor financial decisions
 * Benefits are asset-protected from most creditors
 * Benefits are tax-advantaged - tax-free to many retirees, only up to 85% of benefits are taxable federally, and most states do not tax benefits
 * Benefits have an insurance value, in that they continue as long as the recipient is alive. This provides utility beyond the expected rate of return, in that it provides additional funding for a long retirement that stretches other savings. A taxpayer can buy a SPIA when they retire, but SPIA's tend to have lower rates of return than Social Security, and importantly are not indexed to inflation, so are not nearly as good insurance against high longevity.

Disadvantages include:


 * Taxpayer has no direct influence over the growth of value, as with a traditional portfolio
 * Benefits are illiquid and can't be accessed before filing, or in lump-sum form (without separately taking out a loan and using the benefits to make payments)
 * Benefits are lost at death and can't be passed to heirs, except for spousal benefits which continue until the spouse's death, and survivor benefits for taxpayers who die before retirement age

The risks of Social Security are different than traditional investments. Compared to bonds, there is no interest rate risk, and the credit risk is very low, comparable to other government-backed investments like treasury bonds or TIPS. Compared to stocks, there is no price volatility, nor business or market risk. However, there is a significant legislative risk that the program could be changed in the decades between when a taxpayer pays payroll tax and is scheduled to receive benefits. This risk reduces dramatically, although is not completely eliminated, once a taxpayer files for and begins to receive benefits.

Recommendations
Taxpayers who expect to be in the 90% bracket at retirement should not avoid payroll tax, which is probably one of the best investment that can be made.

Taxpayers who expect to be in the 32% bracket at retirement can expect a modest return. HSA contributions should be made directly to the custodian so as not to avoid the employee half of payroll tax, except for young males and/or taxpayers who would otherwise be able to invest the taxes in a retirement account such as an IRA or 401k. However, older (age 55+) taxpayers in this bracket should not avoid payroll tax in any case.

Taxpayers who expect to be in the 15% bracket at retirement should expect zero or negative real returns from payroll taxes, and should avoid paying them where possible.