Prior to 1935, retirement assistance was solely the responsibility of the individual: the government did not provide financial help to retired workers. However, when the stock market crashed in 1929 and the gross domestic product (GDP) of the United States fell 48 percent in five years (from $105 billion to $55 billion), many individuals and families were left economically devastated. Millions of Americans were laid off, over nine thousand banks failed, and depositors lost over $7 billion in assets. In an attempt to ensure that this type of depression did not happen again, Franklin D. Roosevelt signed the Social Security Act in 1935 to aid individuals who were displaced and unemployed.

The Social Security Program

The Social Security program was designed to be a pass-through account; this means that the taxes you pay for Social Security (through the Federal Insurance Contribution Act, or FICA) are used to pay benefits to those who are currently retired, disabled, widowed, or orphaned. Because there are currently more people paying into Social Security than there are people receiving Social Security benefits, the tax reserves are maintained in interest-earning government bonds held by the Social Security Trust Fund. There was no investment or savings component to Social Security when it was originally set up because the government assumed that there would always be enough people in the working generation to pay for the retired generation’s benefits. In 1935, there were 17 workers for each retiree who received benefits.  Today, it is estimated that there are only be 3..4 workers for each retiree who receives benefits.

Financing for Social Security is split evenly between the employee and employer. All employees pay 7.65 percent of their wages in FICA taxes, which are used to pay for Social Security and Medicare. This FICA tax comprises a Social Security tax of 6.20 percent and a Medicare tax of 1.45 percent.

There is a limit on the amount of wages that are subject to Social Security taxes; this limit changes each year. In 2007, the maximum amount of wages subject to the Social Security tax was $97,500. There is no limit, however, on the amount of earnings that is subject to the Medicare tax. In other words, in 2007, any earnings in excess of $97,500 are exempt from the Social Security tax, but not from the Medicare tax. Table 28.1 shows a historical perspective on changes to this limit.

Table 28.1

Maximum Wage Amount Subject to Social Security Taxes

Employers must provide a dollar-for-dollar match to the funds that employees pay in Social Security and Medicare taxes. Self-employed individuals are required to pay both the employee’s part of the FICA tax and the employer’s part of the FICA tax. This means that self-employed individuals pay 12.4 percent on the first $97,500 of their net earnings for Social Security and 2.9 percent on all taxable earnings for Medicare. However, self-employed individuals may deduct up to half of their Social Security taxes as an adjustment to taxable income on their federal income tax returns. Since 1937, the government has made major changes in the Social Security tax rate. Table 28.2 shows how the Social Security tax rate has changed from 1937 to 1990.

Table 28.2

Social Security Tax Rate Changes

OASDI-HI, which is the official name of Social Security, stands for “Old Age, Survivors, and Disability Insurance and Hospital Insurance.” Individuals must only pay Social Security on taxable wages. Taxable wages include salaries; bonuses; commissions; the value of employer-provided meals and lodging; sick pay during the first six months of illness; employer-paid group life insurance premiums in excess of $50,000; salary reductions from 401(k), 403(b), and 457 plans; nonqualified deferred compensation that is no longer at risk; nonqualified stock options; vacation pay; and severance pay. Nontaxable wages include sick pay after six months, payments made by an employer for medical or hospital expenses, and employer contributions to qualified retirement plans.