(Money Magazine) -- We'll go out on a limb and assume you've heard the rumor that Social Security and Medicare are headed for trouble.
You've seen alarming stats thrown around and maybe wondered what to make of them. (For example, the two programs are said to have a $43 trillion deficit payable over 75 years. Is that a lot? And if it's as big as it sounds, how is the government still running?)
Perhaps you've even slogged through one of the reform plans that politicians, academics and retired CEOs are always dreaming up. But what you really want to know is more basic: How am I supposed to plan for this?
Here's where politics meets your portfolio. And as tricky as it is to guess the direction of stocks, it's even harder to predict the long-run electoral fortunes of Republicans and Democrats or the compromises legislators will hammer out. That said, there are some things you can expect when you get to retirement:
- You'll have a significant Social Security benefit, especially if you're a boomer. The system's problems are quite fixable.
- Medicare, on the other hand, is headed for crisis. A total meltdown. And soon. For the health insurance program to survive, it will have to make huge changes, and you must start preparing for them.
- Both programs will be fixed with a combination of benefit cuts and higher taxes. Many of the higher taxes will be levied on your paycheck. But it's also possible that higher taxes on income and investments will hit you in retirement.
- Well-off retirees - and by that we mean people with pensions and biggish IRAs, not just former hedge fund managers - will increasingly pay stealth taxes on their benefits. And we're not talking about some far-off proposal here. This one's already a done deal.
No matter what happens, Social Security and Medicare (in some form) are still going to play a major role in your retirement. So even if your last day of work is 10, 20 or 30 years off, you need to have a basic grasp of the challenges these systems face and the price you'll be asked to pay to keep them alive and kicking. Getting ready is partly a matter of how much you save - but as you'll see, it also matters where you save it.
Established back in 1935, when the U.S. was mired in the Great Depression, the Social Security program now replaces just under 40% of the average retiree's pre-retirement earnings.
Even for higher-paid workers, it represents a significant source of income: For people who currently earn $100,000 or more on the job, Social Security is expected to replace about 25% of their incomes, on average, in retirement. So it had better be there.
But thanks largely to the baby boom, there's a funding gap in the not-too-distant future. Social Security is a "pay as you go" retirement system - that is, the Social Security taxes that get deducted from your paycheck today are used to pay out benefits to today's retirees.
Right now the Social Security system is taking in more money in tax revenue than it is paying out in benefits, with the surplus being entered into the government's books as the system's "trust fund."
But with so many boomers headed into retirement, that situation is likely to reverse sometime around 2017. Benefits will exceed revenue, and Social Security will have to draw on that trust fund.
By 2041 the trust fund will be tapped out too. At that point Social Security payroll taxes will be enough to fund only about 78% of promised benefits. The oldest boomers will be 95 that year. The youngest will be 77, with perhaps another decade or two of retirement to fund.
As bad as this all sounds, Social Security could be brought into balance without extreme pain. None of the reform proposals that have gotten the slightest political traction, including President George W. Bush's effort, would touch benefits for anyone over 55 when enacted. Retirement ages could be increased, but with life expectancy rising, that may not be so terrible, at least in a white-collar job.
One well-regarded proposal, by economists Peter Diamond and Peter Orszag, would reduce promised benefits gradually, with today's twentysomethings losing just 8.6% of their benefit. Payroll taxes would rise from 6.2% to 7.1% by 2055. That's hardly earth-shattering. And once you were retired, of course, you'd be off the hook for those higher payroll taxes.
But you may not be off the hook for all Social Security taxes. You see, Social Security has been in bigger financial trouble before. And the last time it went in for repair, lawmakers put in place some obscure new taxes on affluent retirees to shore up the system. Those taxes are automatically going to snag more and more people.
To understand these stealth taxes, you have to look back to the early 1980s. Ronald Reagan appointed a commission, chaired by future Federal Reserve chief Alan Greenspan, to come up with ways to keep Social Security solvent. The commission's recommendation: Make the wealthiest retirees pay partial taxes on their Social Security benefits. In 1984 that recommendation became law.
This tax is confusing, to put it mildly. When half of your Social Security benefit, plus all your other income, exceeds $25,000, or $32,000 as a married couple, some of your Social Security benefit starts to count as taxable income. That "other" income includes withdrawals from regular 401(k) accounts and traditional IRAs, as well as payments from a traditional pension plan and any employment income.
It also includes dividends, interest and capital gains on investments - even the interest on tax-free municipal bonds is thrown into the calculation. For each dollar of income over that $25,000 threshold, 50¢ of Social Security counts as taxable income until 50% of your benefit is subject to taxes. (Told you it was confusing.)
There's more. In 1994 the Clinton administration upped the ante. Now when half of your Social Security plus other income tops $34,000, or $44,000 for a couple, you have to add 85¢ of your Social Security to taxable income for each additional dollar of earnings.
And the pain doesn't stop until 85% of your benefits have been tossed into your taxable income. At first these rules didn't affect a lot of people. But here's the catch: Like the dreaded alternative minimum tax, those crucial income thresholds weren't indexed to inflation.
As a result, a third of all retirees are now paying federal income tax on their Social Security benefits. In 10 years, 43% of retirees will be subject to at least some of this tax.
For those caught in it, the tax makes the shelter of 401(k)s and traditional IRAs less valuable than you might have assumed. Let's say you get $24,000 a year from Social Security and draw $22,000 from a pension. That's enough to start moving you into the 85% zone.
Every additional dollar you withdraw or earn will have you reporting an additional $1.85 in taxable income. Hit the 25% tax bracket and that adds up to a 46¢ levy on what surely must have seemed like, and spent like, only a buck of income. Presto: You have an effective marginal tax rate of 46%. Unless, that is, you get your income from somewhere else - but more on that in a moment.
This tax is sticking around, says Andrew Biggs, a Social Security expert at the American Enterprise Institute. "If the government dropped the tax, they'd have to come up with something to replace it, which they don't have," he says.
Medicare: How much trouble is it in?
Three decades after Social Security was established, the federal government created Medicare to fund health care for the elderly. Today the government spends $10,000 every year, on average, on each person enrolled. And with healthcare costs growing at 2.5 percentage points faster than the economy, that number will keep climbing.
The conservative National Center for Policy Analysis notes that by 2050 more than 75% of federal income tax revenue will be soaked up by Social Security and Medicare if benefits and today's tax rates remain in place. It's Medicare that really drives that giant shift.
The Medicare system is several programs. Medicare Part A, which covers hospital care, is funded by payroll taxes and has a trust fund similar to Social Security's. But this is expected to run out much earlier, in 2019. To fix that, the system would have to double its payroll tax today, cut benefits by 50% or some combination of the two.
Part B, which covers doctor visits, and the new Part D, which pays for drugs, are funded by retiree premiums and the government's general revenue. They can't technically go insolvent, but as their costs grow, they'll have to raise their premiums even as they place a mounting burden on taxpayers as a whole.
First things first: Even if nothing else changes, your out-of-pocket medical costs are going to be higher than those of today's retirees. Not only will those Medicare premiums go up, but the many costs Medicare doesn't cover will rise as well.
According to the Employee Benefit Research Institute, a new retiree in 2016 will need to have saved more than $200,000 to cover retirement medical costs, assuming he or she lives to 90 and uses an average amount of prescription drugs. And that's assuming Medicare benefits aren't cut - not a safe assumption.
"There are going to be some major benefit cuts to Medicare in the next 10 years," says EBRI analyst Paul Fronstin. "You can't incrementally work your way out of the insolvency issue."
Benefit cuts could take a lot of forms. Modern health-care delivery is so inefficient that it's theoretically possible to cut out a lot of costs while delivering the same - maybe better - care. But it's just as likely that the Medicare system will do what private insurers have: thrust even more out-of-pocket costs onto you.
On the tax side, meanwhile, Medicare is going to be reaching into a lot of pockets in the coming decades. Since outpatient and drug coverage are financed from general government revenue, simply raising the payroll tax wouldn't fix the problem.
Income taxes could rise. Or capital gains and dividend taxes. Or the estate tax. Any way you slice it, the low rates of the Bush years aren't long for this earth, no matter who wins the November election.
Finally, there's "means testing" - that is, taxing affluent retirees. This has already begun in a small way. Part of the tax on Social Security benefits goes to Medicare. And starting in 2007, high-income retirees have had to pay bigger Part B premiums.
Once the system is fully phased in, retirees earning about $84,000 (or $168,000 as a married couple) will pay an extra $470 a year in premiums. The richest would pay $2,500 more. (The thresholds are adjusted for inflation.)
In the scheme of things, these aren't big bucks - yet. According to the Congressional Budget Office, only about 4% of Medicare beneficiaries pay the higher rate. Still, critics of means testing say the current income threshold is just the beginning.
"To raise any significant amount of money for Medicare, that will have to come down to the $40,000 range," says Maria Freese of the National Committee to Preserve Social Security and Medicare, a liberal advocacy group.
3 ways to plan for it
Your best defense against the coming entitlement tax grab is to generate as much retirement income as possible from sources that don't trigger the tax on Social Security benefits, or throw you over the Medicare means-testing threshold.
One way to accomplish this is to put at least some of your retirement money into a Roth IRA or Roth 401(k). With a traditional IRA or 401(k) you invest pretax dollars and pay taxes when you withdraw your money; with the Roth versions, you pay taxes on what you put in but nothing on your withdrawals.
And once you're retired, Roth withdrawals do not count as income when it comes to determining whether you'll owe taxes on your Social Security or have to pay higher Medicare premiums. "The Roth takes that issue off the table," says Roseland, N.J. accountant and planner Howard Hook.
What's more, a Roth also immunizes you from a rise in income tax rates. Now this doesn't mean Roths will always be the best tax move - for instance, you might fall into a lower tax bracket when you retire. Read here for more on how to use a Roth.
Paying down your mortgage can help too. If you sell your house and spend the proceeds, the IRS won't consider that income for Social Security taxation or Medicare means testing. Likewise, if you pay off your home and borrow against the equity in retirement, that won't get counted as income either.
Of course, raising taxes and cutting benefits aren't exactly popular moves for any politician. They may just try to borrow their way out of the problem, says Laurence Kotlikoff, a Boston University economist who specializes in entitlements research.
But major credit rating agencies have already warned that the federal government's credit rating is at risk of being downgraded if the national debt is not brought under control. Borrowing more to pay for Medicare and Social Security would make this threat even more real. That means the government would have to pay higher interest rates on its debt.
Rising interest rates can hammer your portfolio returns, especially on bonds. And that's an argument for keeping your portfolio tilted to equities, even if you're close to retirement.
For example, at 30 you might aim for 75% in stocks and 25% in bonds. At 45 you'd shift to 70% in stocks, and at 60 you'd reduce your stock allocation to 60% of the portfolio.
Conventional wisdom holds that you can count on spending only 70% to 80% of your pre-retirement income in your golden years. After all, many of the big-ticket costs you incur during your working life, like commuting, contributing to your 401(k) account and paying off your mortgage, will disappear.
But taxes on your Social Security benefits and Medicare, combined with the likelihood of rising medical costs and possible benefit cuts, could easily outstrip those other savings.
To increase your odds of retiring well, start by assuming that you'll need 100% of your pre-retirement income to get you through your later years. To figure out how much you'll need to stash aside every year to get there, use our Retirement Planner calculator.
And if saving more is impossible, you may have to reconsider your retirement date. Working just one additional year increases your annual retirement income by 9%, on average, according to Urban Institute research. No, it's not a silver bullet - there simply isn't one. But every bit of ammunition will help.
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