For you viewers here in 2017, I’ve inserted an article concerning the Social Security and Medicare systems I wrote in early 2012. I’d like to say things look much more favorable today than they did back then . . . but I’m afraid they don’t. Please read on to get a feel for your future retirement and what the government has in store for you.
Social Security: A Misfortune in Progress
On April 23, 2012, the Trustees of the Social Security and Medicare trust funds issued their 2012 report to the public. In it, they acknowledged the long-run actuarial deficits of both programs worsened in 2012, warned that both funds are on “unsustainable paths” and will be exhausted by 2024 and 2033 respectively. After describing in some detail the inherent problems which are bleeding the system, notably the baby-boom generation’s imminent retirement requirements, the 2011 and 2012 reduction in the Social Security payroll tax rate, and the Disability Insurance component fund exhaustion scheduled for 2016, they concluded with the following recommendation: “Lawmakers should address the financial challenges facing Social Security and Medicare as soon as possible. Taking action sooner rather than later will leave more options and more time available to phase in changes so that the public has adequate time to prepare.”
The trustees are correct; the systems face serious problems and timely action must be taken to correct the problems. So what’s the likelihood lawmakers will promptly address the financial challenges? Perhaps a more fundamental set of rhetorical questions are in order. (1) What’s the likelihood the Republican-dominated House of Representatives and the Democrat-dominated Senate will cooperate amicably to solve this or any problem? (2) What’s the likelihood the senior citizens’ lobbying groups will look favorably on a reduction of benefits to their members as a means of reducing the costs of the program? (3) What’s the likelihood middle-class, middle-income, young and middle-age workers will support an increase in their payroll tax rate so to increase the money flowing into the system? (4) And as a final query, what’s the likelihood a sufficient number of legislators will be willing to enact laws which alienate their constituents today so the systems will not default a couple of decades from now? As I said, these are rhetorical questions; they deserve no answers.
At this point I’ll try to provide a touch of reality for you current contributors to the system, meaning those of you from whom FICA taxes are regularly taken despite the fact you’ll see no return of any sort for many years. As you’re now aware of what our elected representatives will be doing to safeguard your long-term interests—essentially nothing—you’d better be prepared to do something for yourself. Unfortunately for the majority of you, you’re without recourse. If you earn a salary, your employer automatically withholds FICA payments from each paycheck. Like it or not, you’re a contributor to the system. When you reach retirement age, whatever the number, you’ll discover what the authorities determine to be your fair share of the retirement pot. The probability is if you’ve worked hard, saved systematically and accumulated some assets your share will be little or nothing.
If there’s any good news, it‘s for that small but select group of persons with the ability to opt out of the system, either partially or wholly. These are generally the self-employed, with a certain amount of investment or other non-earnings income. The following scenario describes how this escape is possible.
Carrie D. Offeré, self-employed real estate broker and investor, age forty-five, unmarried, $70,000 net annual investment income from rents, mortgage interest, and dividends plus $50,000 net business income from real estate brokerage.
Only the $50,000 of business income, reported on Form 1040 Schedule C, is subject to Social Security tax. Currently at 12.3 percent this amounts to $6,150 per year. However, she can avoid this cost by simply forming a corporation from which to operate the brokerage. As corporate income, it’s FICA exempt.
Concurrently, another benefit is a more favorable income tax rate. Corporate income is taxed federally at 15 percent on the first $50,000, this far preferable to the 28 percent rate superimposed on $70,000 of other income. The tax reduction on her $50,000 of income is 13 percent [28 percent – 15 percent] for an additional savings of $6,500. Taking into account both FICA and federal income taxes, an annual $12,650 in reduction is possible.
As simple as this may sound, there are other matters to consider. Foremost among them is the question: what becomes of the corporate income? If passed on as salary it becomes taxable at 28 percent plus an FICA obligation of 7.65 percent to corporation and 5.65 to Ms. Offeré; there’s no advantage in this. A second possibility is a periodic dividend distribution. Although this avoids the Social Security consideration, it raises the specter of double taxation: 15 percent to the corporation plus her 28 percent bracket rate. Once again there’s no benefit.
How then can the problem be resolved? For this technique to work, the income must remain in the corporation as undistributed earnings, meaning it not be required for personal living expenses. With Ms. Offeré’s investment income, and reasonable frugality, she can pull it off. Thus the corporation will, over a period of years, accumulate net worth. That, however, raises an additional hurdle called the accumulated earnings surtax of 15 percent. The Internal Revenue Service does not like to see corporations hoard earnings as it interferes with the double taxation they understandably find to their liking. Fortunately there’s some leeway. An accumulated earnings credit of $250,000 prevents assessment of the tax until the aggregation reaches that amount. Also, any portion of the cache used for reasonable needs of the business may be further excluded. With prudent management, “reasonable needs” can be found for these funds. What sort of purposes, you might ask? Here is where it gets stickier. To avoid personal holding company status, and yet another 15 percent surtax, the corporation must restrict its investments so not to exceed specific percentages of certain types of income, most importantly interest, dividends, rents, and royalties.
I’ll conclude this topic with a troubling prognosis. There is no way future recipients of the system can avoid the unhappy future in store for Social Security. It will ultimately morph into a welfare system to which all will contribute, but from which only the destitute will collect. Whatever you can do to avoid its grasp will be to your individual benefit. Unfortunately, those of you impressed into the system have no choice but to hope for the best. As with so many other misfortunes flesh is heir to, each of us must fend for ourselves, as best we can.