What You May Not Know About the Payroll Tax Cut (Social Security Funding Decrease)

If you were following the news at all before Christmas you probably know that the Republicans once again put politics before their principles and agreed to a two-month extension of the payroll tax holiday.  As is a Republican tradition, they of course did this only after doing as much damage as possible by saying they would not extend the tax holiday.  They thereby managed to irritate both their base who was calling for an end to the holiday and the general public who wanted the holiday extended.

Here are somethings that were not widely reported about the deal, however:

1.  The “Payroll Tax” is the funding paid by workers and businesses to fund Social Security.  Up until about a year ago, workers and their employers each paid 6.2% of the worker’s salary into the system.  Since the holiday, the worker is paying only 4.2%.  This means that the funding for Social Security has been reduced, increasing the rate of demise of the system.  To protect yourself, all SmallIvy readers should put the $1000 not paid into Social Security this year into an IRA.  You have until April 15th.

2.  The bill also included an extension of unemployment benefits and the “Doc Fix.”  The Doc Fix is a provision that keeps the payment rates from Medicare to doctors from being lowered as is written in the law.  The lower payment rates are often cited as a cost reduction (as they were in the scoring of the Obama Health Care Law, allowing it to appear to reduce costs), but it is widely known that they will never take effect since doing so would cause a lot of doctors to stop seeing Medicare patients.  Each time the lower rates are about to go into effect, a temporary stop is passed.

3.  The bill from the Democratic-controlled Senate to the Republican-controlled House included income level phase-outs.  This meant that those at the higher end of the middle class income spectrum would see some of their income being taxed at the higher 6.2% rate, while those at the lower end would be paying 4.2%.  This would make Social Security more of a welfare program than it currently is since individuals at the lower-end of the income spectrum would be paying less for benefits than those in the upper-middle class.  Note that most wealthy individuals have little payroll income (or realized income at all) compared to their wealth and therefore would be unaffected.  This is a good reason to save and invest to become wealthy rather than working for all of your income.

4.  To pay for the 2% payroll tax extension, an additional charge would be created in the fees charged by Fannie Mae and Freddie Mac to loan originators.  These fees would be passed along to the home buyer, resulting in an increase of about $15 per month in the mortgage payment.  Note that this would be about $180 per year or $5400 over the life of a 30-year loan.  Including interest, a home buyer would pay somewhere north of $10,000 over the life of the loan.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Privatize your Social Security Account

In Congress there is a current debate over the extension of the payroll taxes.  Payroll taxes is liberalese for Social Security taxes – a term that is used whenever it is desired to make Social Security taxes seem like a tax and then not connect it to Social Security.  (The term Social Security contributions is used whenever it is desired to make the system look like a pension program.)

As I’ve stated numerous times in the past, the Social Security program will not be there providing benefits whenever anyone who is reading this and whom is under 50 is ready for retirement.  Those who are 50-55 may also not see any benefits.  (The tax will likely still be there since taxes die very slowly.)  There is nothing political about this assertion, it is simple mathematics.

Social Security is designed to be a pay-as-you-go system, in which people who are working pay in money that is collected by those who are retired.  The expectation then is that those who are working now will be paid by those who come after them.  Theoretically the amount that is paid in should be scaled to match the amount needed by those collecting, but in actuality the excess is simply put into the general fund through some accounting gimmicks and then spent.

The trouble is that a huge number of people are set to retire in the next few years.  This means that a lot more people are going to be collecting Social Security and for a longer period of time, given advances in modern medicine.  Unlike a traditional pension fund where the excess money that had been paid in by this large number of people would have been sitting there in equities, the excess money was spent.  This means that either those whom are working now will need to pay more to cover those who are retiring or those who are retired will need to be paid less.  Neither one of these options is politically popular, so I would expect payments to be made as long as possible until either a group of more responsible individuals are elected who wind down the program or the government runs out of money and the ability to borrow more entirely and is forced to stop paying.

Even if the program were to survive, however, the amount that one receives will be far less than one would have received if the same amount of money were invested in a  private account.  This is because invested privately, the money is used to fund businesses that grow, creating value, which in turn would provide a substantial profit on the investments.  The current system can only return what the Government can extract from the taxpayer.

The current payroll tax holiday, however, provides an opportunity to receive those private account returns without finding any more money to invest.  Simply take the extra amount you are receiving each paycheck and use it to fund a private IRA account.  Because this is money you would not be receiving anyway if there were no payroll tax holiday, as long as you resist the urge to spend it on things you were not buying before, this money should be readily available.  As added incentive, realize that reducing the amount people are contributing to pay Social Security benefits is only hastening the demise of the system, so personal savings will become even more critical.

If you like the idea of saving your money in a private account, perhaps drop your representatives a line asking them to preserve the payroll tax holiday indefinitely and increase the amount that is allowed to flow into your IRA each year by a like amount.  To pay for it, we can simply reduce the future Social Security benefits that you would receive.  I’m doubtful that you would receive them anyway, so it should not be any big loss to lose them.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Will Privatization of Social Security Work? Here’s a Chance to Find Out.

Ask SmallIvy:  Please send investing questions to vtsioriginal@yahoo.com or leave in a comment.

You may have heard various candidates talk about privatizing some or all of your Social Security savings.  They say that instead of sending all of the money into the government to distribute, a portion or the whole sum should be put into private accounts that workers control.  Proponents (myself included) claim that this would result in significant increases in the amount people receive when they retire.  The mere mention of privatization, however, immediately results in dire warnings of the risk of putting worker’s retirement funds in the stock market.  The campaign letters then go out to seniors warning that their Social Security is in peril, ads are broadcast of reformers pushing old ladies in wheel chairs over cliffs, and the issue goes away in favor of the status quo.

Because such scare tactics are so effective, and therefore there has never been enough political stomach to actually privatize any of the funds contributed to Social Security, the idea that doing so would bring better results remains untested.  Ironically, however, the current payroll tax holiday, offers a chance to do just such a test.  How would this work?

Well, you may have noticed that your take-home pay has been a little bigger lately.  This is because the payroll tax on the worker side has been decreased from 6.2% to 4.2%.  This means that if you make $50,000 per year, you’ll be taking home an extra $1,000 per year.  While this may be too little to result in any economic stimulus, as was envisioned, it is plenty to perform a little experiment.  Since this is “found money,” instead of just blowing it on something, why not pretend your takehome pay is the same and use the money that would have been going to Social Security to see what privatization would be like.  After all, if you lose it all you would be in the same position as if you had sent the whole amount into the government in Social Security taxes.  Here is the experiment:

Take the extra take-home pay and start saving it in a savings account or in a drawer in your home.  Once you have $1000 saved (which will take about a year if you have a gross income of $50,000), call Vanguard (who recently lowered their minimums to $1000) and put the money into one of their equity mutual funds.  Good choices would be the S&P 500 fund, the Mid Cap fund, or the Small Cap fund.  Then, as long as this payroll tax holiday lasts, keep putting the extra into the fund.  You can even set up automatic withdraw to Vanguard so you don’t forget.

Once this is done, continue the monthly investments or, if you are worried about the market, just stop the deposits but leave the initial investment.  Then, forget you have the account for 10 or 20 years.

If I’m right, when you check back in 10 years, you’ll probably have something like $2300 in the account if you just made the $1000 minimum and nothing else.  In 20 years, you’ll have about $8,000.  In 50 years, you’ll have about $128,000.  In 56 years, you’ll have about $256,000.  With that money, you could take a withdrawal of about $30,000 for the rest of your life if you lived until you were 90 years old before exhausting the money.

So, if I’m wrong, you’ll be out $1000.  If I’m right, you’ll have $256,000 in 56 years.  If I’m a little wrong, you’ll have $100,000 in 56 years.  Anyone willing to give it a try?

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Some final Calculations about Social Security

This will be my final post on the subject, since I’m sure some are bored with the topic.  I wanted to provide some final information, however, to hopefully convince those reading this blog that private Social Security accounts would be a great idea.

Using the equations of compound interest and the historical returns, I calculate that at age 65 one would have an inflation adjusted $9 million dollars if one invested $10,000 in a broad basket of stocks at age 20 and did nothing else.  In Social Security, with it’s after-inflation return of 0.5%, one would end up with about $12,500.

Further, the money in stocks is there.  The money in Social Security would need to come from others and may not be there, or the rates could be changed, etc….  It is up to the politicians who are elected, and those of the last 50 years have clearly shown that they cannot manage money – note the current national debt that would stretch out past Saturn if converted to $1 bills placed end to end.     Yes, the entire financial system could collapse, or there could be a nuclear war and wipe out stocks, but then one wouldn’t receive Social Security either.

Further, if the 20-year old died at age 64, he would receive nothing.  With a private account, he could leave his stocks to his heirs or his favorite charity.

Let’s say stocks don’t do as well as they have and my interest rate assumptions are off a little.  Let’s also say that it would be stupid to leave $5 million entirely in stocks when one is 60 and will need the money in five years, so some would be shifted to cash and bonds starting at about age 55, decreasing the return somewhat.  Even so, $9 Million is a lot more than $12,500.  $5 million is a lot more than $12,500 too.

I think it is a great idea to have people save some of their income for retirement.  After all, everyone will need to retire someday and will need money for food and necessities.  The current system is broken, however, because the money is not able to build up over time and is subject to the whims of the political class.  The current system with the subtle tweak – of changing from a public system to private accounts – makes sense.  I’ll admit that limiting investment choices to ensure proper diversification and asset mixes based on age would also make sense.  You could even automate the distributions if you so chose.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.comor leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Why Private Accounts Would Be So Much Better than the Current Social Security System

Wealth – a mass of things of value for which someone would be willing to trade or work for – is created through work.  It is also created through the extraction of natural resources.   If work is used to provide services (hair cuts, lawn mowing) or things that are used or destroyed (rock concerts, food), then the net wealth of society is fixed.  If you have a magic coin and I give you a haircut for that magic coin, after the haircut I now have the magic coin and in two weeks you no longer have a haircut, so the wealth of the world is still one magic coin.  I could also just club you over the head and take the magic coin without giving you the haircut and the net effect would be the same, although you would be less happy (just like with Social Security taxes).

Let’s say that instead of giving you a wasting asset like a haircut, I dig up some ore and create a knife and trade it for your magic coin.  As long as you take care of it, the knife will last indefinitely.  This time instead of the fruit of my labor decaying away, I have created wealth.  The wealth of the world is now doubled and worth two magic coins – one in the form of a knife, and one in the form of a magic coin.

Social Security in its present form, from a cash-flow perspective, is like me clubbing you over the head and taking your magic coin.  When you do work and I take it from you without providing anything of value in return (other than perhaps some nice stories about the good ol’ days), the amount of wealth in the world is decreased when I use up the result of your work (for example, the food you grew).  When you are ready to retire, if there is someone who is willing to allow you to take the result of his labor without immediate compensation, then you will be fed.  This can continue indefinitely so long as there are enough people still working, although there is only a certain amount that can be taken from the still working before they will stop working. This means that you may get just enough, or almost enough, but you won’t get a huge excess.  After all, the next guy needs to eat too.

The problem comes when you have a large bump in the population – the Baby Boom.  If you were to have those Boomers, while working, pay enough to pay for themselves and those currently retired, and you were to store the excess taken somehow until the large bump in the population retires, those coming after them would only need to provide as much as the generations before them provided since the additional revenue needed would be there in storage.

But the wealth, while taken, was not stored because Social Security is a pay-as-you-go system.  Extra revenue beyond what is needed to pay for current retirees was spent on other things – nuclear missiles, EPA studies, White House Dinners, trailers for hurricane victims, schools in Iraq, etc….  This means that as the Boomers are starting to retire, the amount of wealth being taken from those after them (Gen X) is not enough to provide the same level of benefits unless the amount being taken is increased.  This means that either the Boomers will see their benefits cut or the Gen Xers will need to provide far more than they get.  It probably will mean a little of each.  This is where we currently are.

But let’s say now that instead of me clubbing you over the head and taking your magic coin, I use my wealth to create things of value – say a knife or a table – and then store them until I retire.  Things that I can give you for your magic coin which you will gladly accept because they are useful and therefore valuable.  As I am selling my tables and knives to you for your magic coins, even though I use the magic coins up to sustain me, you still have the knives and tables which you can trade for magic coins from someone else when you are ready to retire.  No one needs to get clubbed over the head.

Now, instead of saving up tables or knives, let’s say that I trade my labor for interests in  corporations.  These things don’t only hold their value – they grow in value.  As the corporation starts to generate more revenue, by providing something that other people are willing to do work or trade something they have of value to obtain, the corporation  becomes more valuable.  The amount of wealth in the world is increased.  When I sell my shares of stock, I am not draining anything from those still working – I am trading something for something.  I am not just banking the wealth created by my labor – I am growing it.

And no, contrary to the myth currently being presented, it is not true that those who have invested in the stock market have only done about as well as the “investment” in Social Security or done worse.  They have done better – far better.  The return on stocks over the last 50 years has been over 10%, even with the 2000 and 2008 crashes.  The return on Social Security has been about 1%.  This is the difference between getting $10,000 per month in retirement and $10,000 per year.  (A more thorough analysis will come in a future post to show the difference.)

So, if we keep doing as we’re doing – clubbing the next generation over the head and stealing their magic coins, the ability to feed the current generation will always be dependent on the work of the next generation.  If too much of that work is expended for other purposes – for example for paying for wars or interest on debt – there will not be enough available to feed current retirees or the next generation will effectively become slaves with nothing to show for their labor.  If retirees instead have saved their work over their lifetimes for themselves, in things that have value, there will be no such dependency and both generations can enjoy the fruits of their own labor.