How Is Social Security Funded? Everything You Need to Know

Social Security is a crucial source of income for millions of Americans, but how much do you really know about how it’s funded? With over 70 million beneficiaries receiving payments in 2022, understanding the basics of Social Security funding is essential.

An average of 68 million Americans, including retired workers, disabled individuals, and their families, have received social security benefits each month this year. For many seniors, Social Security is their primary source of income in retirement. But with the program’s trust funds projected to be depleted by 2035, there’s widespread concern about the future of this vital safety net. 

So, how is Social Security funded? In this article, we’ll dive into the nuts and bolts of who pays for Social Security and how. Whether you’re currently receiving benefits, nearing retirement, or have years of work ahead of you, you need to know this information. By the end, you’ll have a clearer picture of how your Social Security taxes are used and what needs to happen to keep the program strong for future generations. 

Where Does Social Security Money Come From?

The majority of Social Security’s funding comes from payroll taxes, which are taxes taken out of workers’ paychecks and matched by their employers. Here’s a closer look at who pays for Social Security and how. 

FICA Tax

If you’ve ever looked at your pay stub, you’ve probably seen a deduction labeled “FICA.” This stands for the Federal Insurance Contributions Act, and it’s the law that mandates Social Security taxes. 

Social Security Tax

For 2023, the Social Security tax rate is 6.2% for employees and employers. That means that for every $100 you earn (up to $168,600), you pay $6.20 in Social Security taxes, and your employer pays another $6.20. If you’re self-employed, you pay 12.4% through the Self-Employment Contributions Act (SECA) tax.

Payroll Tax

Payroll taxes are collected on wages up to a certain amount each year, known as the “taxable maximum” or “wage base limit.” In 2024, this limit is $168,600. Any earnings above that are not subject to Social Security taxes.

Additional Funding Sources

While payroll taxes account for the lion’s share of Social Security’s revenue—about 90% in 2023—two other sources help fund the program:

1. Taxes on Benefits: Some of your Social Security benefits may be subject to federal income taxes if your income exceeds certain thresholds. The revenue from these taxes goes back into the Social Security trust funds. 
2. Interest on Trust Funds: When Social Security collects more taxes than it pays out in benefits, the excess funds are invested in special U.S. Treasury bonds. The interest earned on these bonds is another source of income for the program.

In the early days of Social Security, the program was funded through employee, employer, and government contributions. The government contributions were phased out in 1950, leaving the system reliant on payroll taxes and interest income.

Is Social Security Government-Funded? Exploring Trust Funds

The money collected from Social Security payroll taxes, income taxes on benefits, and interest doesn’t just sit in a big pile somewhere. It’s deposited into two trust funds critical to the program’s operations and ability to pay benefits.

1. The Old-Age and Survivors Insurance (OASI) Trust Fund: This fund pays retirement benefits to seniors and survivors benefits to the families of deceased workers. In 2024, nearly 60 million people and their dependents are receiving benefits from the OASI fund.
2. The Disability Insurance (DI) Trust Fund: This fund benefits disabled workers and their families and supports over 8 million disabled workers. 

While legally separate, the two funds are often referred to collectively as the OASDI trust funds or simply “the Social Security trust funds.” Here’s a simplified look at how the trust funds operate:

1. Income: Payroll taxes, taxes on benefits, and interest payments are deposited into the trust funds. 
2. Investments: When more money comes in than goes out in benefit payments, the surplus is invested in special-issue U.S. Treasury bonds. The full faith and credit of the federal government backs these.
3. Benefit Payments: When current tax revenue isn’t enough to cover all benefits, the trust funds redeem their Treasury bonds to make up the difference. The Social Security Administration uses this money to send benefit checks (or direct deposits).

The Demographic Trends Straining Social Security

Social Security is often described as a “pay-as-you-go” system, meaning today’s workers primarily fund benefits for today’s retirees and other beneficiaries. That model worked well in the program’s early decades when there were many more workers than beneficiaries. 1960, for example, there were about five workers for every Social Security beneficiary. 

However, as birth rates have fallen and life expectancies have increased, the ratio of workers to beneficiaries has shrunk dramatically. In 2023, there were about 2.7 workers for each beneficiary. By 2040, the Social Security Trustees project that there will be just 2.1 workers per beneficiary.

At the same time, the number of beneficiaries is multiplying as the Baby Boomer generation retires. Right now, there are 56 million retirees. By 2035, there will be more than 78 million retirees, meaning more people will receive benefits than paying into them. 

What Happens if the Trust Funds Run Dry?

These demographic shifts mean Social Security pays more in benefits yearly than it collects in non-interest income. To account for this, the program draws on trust funds. But those funds are finite, and the latest projections from the Social Security Trustees show they could be depleted by 2035.  

If that happens, Social Security could only pay about 83% of scheduled benefits using its annual tax income. That means beneficiaries could face a sudden 17% cut to their payments unless Congress acts to shore up the program’s finances before then.

The Long-Term Funding Gap

Looking beyond the trust fund depletion date, Social Security’s actuaries estimate the program faces a long-term funding shortfall of 1.2% of GDP over the next 75 years. In other words, to keep the program fully funded over that period, payroll taxes would need to increase by about 3.4 percentage points, benefits would need to be cut by about 22%, or some combination of the two.

Despite these challenges, Social Security remains a crucial source of income for millions of seniors, disabled workers, and their families. It provides the majority of income for about half of seniors and at least 90% of revenue for nearly 1 in 4 seniors.

The program also plays a vital role in reducing poverty and income inequality. Its progressive benefit formula means lower-income workers get a higher replacement rate than their pre-retirement earnings. In fact, for a low-earner retiring in 2024, Social Security replaces about 78% of their pre-retirement income compared to about 28% for a high-earner.

Options to Strengthen Social Security

Fortunately, policymakers have proposed various changes to improve Social Security’s long-term financial outlook. Here’s a look at some of the main categories of options:  

Revenue Increases

• Raising the Payroll Tax Rate: Gradually increasing the Social Security payroll tax rate from 12.4% to 14.8% over the next 20 years would eliminate about half of the program’s long-term funding gap.
• Lifting the Wage Cap: In 2024, earnings above $168,600 aren’t subject to Social Security taxes. Raising or eliminating that cap could significantly boost the program’s revenue. 
• Dedicating Other Taxes: Some proposals call for diverting a portion of other federal tax revenue, such as from estate or income taxes, to the Social Security trust funds.

Cost Reductions 

• Increasing the Retirement Age: The retirement age gradually rises from 66 to 67 for those born in 1960 or later. Some proposals would accelerate the increase or index of retirement age to rising life expectancies.
• Modifying the Benefit Formula: Changing how initial benefits are calculated, such as using a less generous inflation measure, could reduce Social Security’s long-term obligations.
• Means-Testing Benefits: Some proposals would reduce or eliminate benefits from having full benefits to partial for higher-income retirees. However, this would weaken the link between contributions and benefits, which has been a key feature of the program.

Of course, these changes would be challenging politically. Surveys consistently show that most Americans oppose cutting Social Security benefits while raising taxes, which is always a heavy lift in Congress. However, the longer policymakers wait to address the program’s challenges, the more abrupt and severe any changes will likely need to be.

Why Social Security’s Funding Matters for Your Future

Social Security is a bedrock of financial security for millions of Americans, and it’s not going anywhere anytime soon. Even if the trust funds were depleted, the program could still pay 83% of promised benefits using its tax income alone.

But, the program’s long-term funding gap is real, and the sooner policymakers address it, the more gradual and less disruptive any changes can be. 

As a current or future beneficiary, it’s essential to understand where your Social Security benefits come from and the demographic trends putting pressure on the program’s finances. By staying informed, you can better plan for retirement and assess any proposed changes to this critical safety net.

The debate over how to reform Social Security will surely be a central issue in the years ahead as the trust fund depletion date approaches. However, with a clear understanding of the facts and a willingness to make hard choices, policymakers can put the program on solid ground for future generations.