How Social Security Works
What comes in, what goes out, and what gets taxed
When you get a paycheck, a payroll tax is levied on your earnings (under Federal Insurance Contributions Act tax, or FICA; or under Self Employed Contributions Act Tax, or SECA).
This deduction is your contribution to Social Security benefits.
Money deducted from your paycheck for Social Security is not invested in or deposited in a fund for you to collect later: rather, today's Social Security deductions are used to pay today's Social Security benefits.
To become eligible to receive Social Security benefits, you must have worked for 40 quarters (a quarter being a three-month period). The Social Security Administration (SSA) calculates your average indexed monthly earnings (AIME) based on the 35 years in which you earned the most money. Then they apply a formula to determine a basic benefit, or primary insurance amount (PIA).
When it's time for you to retire, you decide when to claim Social Security benefits. It's also possible to receive Social Security benefits and continue to work at a job.
Are my benefits taxed?
If your Social Security benefits are your only source of retirement income, then in most cases your benefits will not be taxed.
If, however, you have substantial retirement income in addition to your Social Security benefits (e.g., a pension or income from investments), you will likely need to pay taxes on your benefits.
Depending on what U.S. state you live in, you may have to pay state tax on your Social Security benefits, in addition to federal tax.
How is Social Security funded?
Remember how Social Security works: working people pay into the system through a payroll tax, and benefits get paid out to people who claim.
- If revenue from the payroll tax is greater than the amount of benefits needing to be paid, the difference is allocated to a group of funds collectively called the Social Security Trust Funds.
- If revenue from the payroll tax is less than the amount of benefits being paid, the Social Security Administration runs a deficit.
The federal government can deal with that deficit either by increasing the payroll tax, decreasing Social Security benefits, or borrowing money to help reduce the deficit. Such measures may affect the potential amount of your benefit payments you receive.
The Social Security Administration determines your benefit amount. While you can't change how your benefits are calculated, you can control when and how you claim your benefits.