How does social security work?

[bright_shiny_life]

Hi there,

I've been thinking about moving into a different work situation lately and i'm nervous about letting go and being an entrepreneur, essentially. I started thinking about social security and i'm surprised that my basic questions don't seem to be answered out there.

1) Is the idea that the full amount that you save in social security over your lifetime supposed to come back to you in retirement? Just asking this at a high level, i think i've seen various adjustments that are made based on income amount and inflation.

2) If i stopped working at a traditional soc security taxing job now, FOREVER, for example, which would mean i have about 17 years of normal job paying social security taxes, would i receive the same amount at retirement that i would get if i continued to work another 15 years? Assuming my income amount didn't change much.

Obviously, i would not have trad income for next 15 years, so that's a "loss" in some folks eyes, but i'm trying to understand what, if any, impact, it has on social security after retirement.

thanks!
b_life

[maizefolk]

#1 No. You can calculate your estimated payments. The formula is a bit complex (I'm happy to talk more about this if you would like) but there are various online calculators you can use as well.

#2. If you stopped having income, your social security payments at retirement would be a lot less. But if you start a small business you will likely have self employment income where you pay both halves of your social security tax (employer + employee), so those years of work, and the income you earned during those years, will still count towards whatever your social security payout at full retirement age is.

[jim555]

Shows how it is calculated.
https://www.ssa.gov/pubs/EN-05-10070.pdf

[OtherJen]

#2. If you stopped having income, your social security payments at retirement would be a lot less. But if you start a small business you will likely have self employment income where you pay both halves of your social security tax (employer + employee), so those years of work, and the income you earned during those years, will still count towards whatever your social security payout at full retirement age is.

Yes. I'm self-employed and I pay both the employer and employee FICA tax.

[omachi]

See Jim's link. It's a simple explanation.

For #1, that's not the idea. The benefit (as a percent) you get goes down as average income over 35 years goes up, despite being a flat tax taken on that income. Based on your average monthly SS taxed income over those 35 years, you get something like 90% of the first ~$900, then 32% up to ~$5400, then 15% on the rest. As it's a social safety net, that makes sense. People with means can save more easily than those without.

For #2, no, that's also not how it works. Your benefit is calculated off the highest 35 years of work. You add all that up, then divide by 420 - the number of months in 35 years. That's your average monthly income for SS benefit calculation. Any years you aren't working an SS taxed job you take a $0.

What the answer to #2 does mean, however, is that you may have significantly diminished returns out of SS if you keep working an SS taxing job. If you've made $376k that you've paid SS taxes on (less, actually, due to inflation indexing) then additional earnings only add to your benefit at 32%. Or 15% if you've topped ~$2.27M.

[FIREin2018]

#2. If you stopped having income, your social security payments at retirement would be a lot less. But if you start a small business you will likely have self employment income where you pay both halves of your social security tax (employer + employee), so those years of work, and the income you earned during those years, will still count towards whatever your social security payout at full retirement age is.

Yes. I'm self-employed and I pay both the employer and employee FICA tax.

why not s-corp or llc?
have profits flow through to your 1040, and bypass paying employer/employee fica?

[maizefolk]

#2. If you stopped having income, your social security payments at retirement would be a lot less. But if you start a small business you will likely have self employment income where you pay both halves of your social security tax (employer + employee), so those years of work, and the income you earned during those years, will still count towards whatever your social security payout at full retirement age is.

Yes. I'm self-employed and I pay both the employer and employee FICA tax.

why not s-corp or llc?
have profits flow through to your 1040, and bypass paying employer/employee fica?

This assumes the income is passive which is generally won't be if you're actively creating a business on your own.

If you work in the business you've created, best case you can shelter some but not all of your income from FICA as dividend payments, and how much seems to be one of those "squishy" things where you find out its too much when the IRS comes after you, so most people err on the side of calling less of their S-corp income dividends.

[MDM]

A couple of spreadsheets and a web tool that work well for calculating an individual's benefit:
- The 'SocialSecurity' tab of the personal finance toolbox spreadsheet.
- The Downloadable Social Security Benefit Estimator (repost) - Bogleheads.org.
 - Social Security Calculator
A web tool that evaluates SS benefit start dates for a couple:
Open Social Security: Free, Open-Source Social Security Calculator

[Arbitrage]

Hi there,

I've been thinking about moving into a different work situation lately and i'm nervous about letting go and being an entrepreneur, essentially. I started thinking about social security and i'm surprised that my basic questions don't seem to be answered out there.

1) Is the idea that the full amount that you save in social security over your lifetime supposed to come back to you in retirement? Just asking this at a high level, i think i've seen various adjustments that are made based on income amount and inflation.

2) If i stopped working at a traditional soc security taxing job now, FOREVER, for example, which would mean i have about 17 years of normal job paying social security taxes, would i receive the same amount at retirement that i would get if i continued to work another 15 years? Assuming my income amount didn't change much.

Obviously, i would not have trad income for next 15 years, so that's a "loss" in some folks eyes, but i'm trying to understand what, if any, impact, it has on social security after retirement.

thanks!
b_life

Others have answered or provided links, but I'll toss in my two cents.

1. There is no expectation that you'll get back what you paid in, before or after any particular rate of return. 
Assuming you meet the minimum requirements (generally at least 40 credits/10 years of paid wages), there are two breakpoints/'knees in the curve' for how much credit you get for your contributions.  Basically, you earn a huge amount toward your Primary Insurance Amount (PIA, what your monthly SS check is based off of) for the first few bucks you earn.  That gets cut by close to 2/3 for the next big chunk of earnings, and then cut in half (give or take) for the rest of your earnings, if you earn enough. 

You also only get credit toward your Average Indexed Monthly Earnings (AIME) for your highest 35 years of income, indexed for inflation.  Not so important for most people shooting for FI, but does further highlight how there's only a loose relationship between what you put in and what you get back. 

2. No, you'd earn more SS benefits if you kept working for the extra 15 years.  Your AIME will rise for up to 35 years of contributions (more than 35 years, and you'll just get credit for the highest, displacing any lower years).  Your PIA, though, would likely increase on a diminishing returns basis as I described above with the two knees in the curve.  In all likelihood, depending upon your specific numbers, your PIA would not be anywhere near twice as high working 32 years rather than 17. 

[PDXTabs]

why not s-corp or llc?
have profits flow through to your 1040, and bypass paying employer/employee fica?

Because if the IRS notices they will come down on you hard. You might be able to take some of your profit this way, but if you don't pay yourself a reasonable salary they will be very displeased if you are ever audited.

[OtherJen]

why not s-corp or llc?
have profits flow through to your 1040, and bypass paying employer/employee fica?

Because if the IRS notices they will come down on you hard. You might be able to take some of your profit this way, but if you don't pay yourself a reasonable salary they will be very displeased if you are ever audited.

Yep. I earn enough as a contractor to make a reasonable salary for myself, but not enough to justify the hassle of an s-corp. I'm teetering at the edge of an LLC being worth it.