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Al Jacobs invites you to take a look at his most recent book, Roadway to Prosperity, which embodies the heart of his nearly half-century in the investment business.  You'll find a wealth of information there.

 

ROADWAY TO PROSPERITY

IS SOCIAL SECURITY A GIGANTIC PONZI SCHEME?

A half dozen years ago Texas Governor Rick Perry, participating in a Republican presidential debate, made this comment concerning Social Security: “People who are on Social Security today are individuals at my age in line to get them and they don’t need to worry about anything.  But we Republican candidates are talking about ways to transition this program, claiming it is a Ponzi scheme and telling our kids that are 25 or 30 years old today, you’re paying into a program that’s not going to be there.” Did he mean what he blurted out?  Let’s look a little closer to see whether there’s any accuracy to the accusation.

Before I declare whether the Social Security system is or is not a “Ponzi Scheme,” let me provide a little background information.   Charles Ponzi, instigator of the scheme, was born in 1882 and immigrated as a young man to Boston, Massachusetts, by way of Canada.   His occupations during his life included grocery salesman, sewing machine repairman, cafe waiter, and hot dog stand operator.  After several prison terms and eventual deportation, he ended his days in Brazil, dying penniless in a Rio de Janeiro charity ward in 1949.  He receives but minor mention in encyclopedias, and relatively few accounts exist which document his life on earth.  However, for one short period from December 1919 to August 1920 he personified success.  By purporting to earn huge returns from postal reply coupons, he sold short-term notes to the public, paying off earlier note purchasers with receipts from later customers.  Not unexpectedly, when the investors ultimately began to doubt his ability to honor the note commitments, his financial collapse promptly followed, with imprisonment not long afterward.

If you detect any connection between the Social Security system and the revelations of this tale, perhaps it’s that money is collected today to pay sums to those who decades ago paid significantly lesser amounts.  For those of you who plan to rely upon the government’s assurance of long-term solvency of Social Security, you must delve a little more closely into past administrators’ reports.  They state social security tax revenue will become inadequate to fund future benefits, with the trust fund depleted by 2037.  They further project annual surpluses will “fall sharply,” to remain at reduced levels for the foreseeable future.  Note that nationwide unemployment is officially less than 5%, but in reality closer to 20% if you count all the persons actually unemployed – there are fewer workers contributing into the system.  This puts a stark reality on the actual conditions and intensifies the political debate over how quickly this nation must tackle Social Security reform.

Government officials, speaking anonymously, report this impending gap requires Congress to increase FICA payroll tax and reduce benefits.  Acknowledging that the resources which ostensibly secure the two trust funds “exist only in paper form, not by any actual assets,” it becomes clear each Social Security recipient is protected only by an expectation of full faith and credit.  If the system cannot be promptly revamped so to prevent its anticipated cash drain, it faces a bleak future.

Does long-term solvency, as successive administrations have assured us, imply future social security recipients will enjoy the sort of benefits current recipients receive?  I’ll risk the government’s displeasure and offer a somewhat different prediction on Social Security’s future.  Let’s fast-forward a few years as 77 million retiring baby boomers continue to swell the system’s ranks.  With actual payments now exceeding collections and general insolvency forecast for 2037, will the government actually allow the system to generate an outpouring of red ink which would bankrupt the nation?  It’s my belief no administration will permit economic destruction of the nation merely to maintain an economically unfeasible illusion.

Now that I’ve revealed what will not happen to social security, you’re entitled to know what will happen.  Regardless of philosophic inclination or party affiliation of persons elected to executive and legislative office, there’s really not much choice.  An economically unsustainable agenda cannot continue indefinitely.  At some point it must either become viable or self-destruct.  And that is what it will become – viable.  As the money runs out, contributions will rise and benefits will shrink.  There is, of course, a practical limit beyond which the FICA tax may not extend.  As with all taxes, the limit is one of “collectability,” usually reflecting the point when political considerations overrule the attempt to extract further revenue.  The matter of shrinking benefits is easier to envision.  Expected changes will include full rather than just partial taxability for those above an income threshold.  Following will be systematic reductions of those limits until social security benefits become fully taxable to all recipients.  The next modifications will be a further increase in the retirement age as a prerequisite for eligibility as well as a reduction in the size of retirement payments to wealthy Americans.  This is merely the start.

The major changes will begin when the situation becomes more aggravated.  Within a generation means testing, and eventually assets limitation, will convert it into a system to which all will continue to pay, but only those who qualify as needy will receive benefits.  The real pity, of course, is today’s young and middle-age, middle-class, middle-income citizens are being bled to death to sustain a fiction from which they will receive, at best, a pittance

For those of you disillusioned with Social Security, I understand your plight.  To watch your FICA tax money pour out in an unending stream is disheartening, particularly as the politicians continue to haggle among themselves over minutiae.  We are witnessing business as usual while a bevy of modern day Neros fiddle.  But, perhaps the saddest part of all is that for the mass of you paying the bill to maintain this sinkhole, there is nothing you can do about it.  You will continue to sustain the labyrinth during its transition into the welfare system it will become.

I said there’s nothing you can do about it, which is true for most persons.  If, however, there’s any good news, it’s for a 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 15.3 percent this amounts to $7,650 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 currently 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 $14,150 in reduction is possible.

As simple as this sounds, 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.  This, 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 is 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.

If I’ve just confused most of you, I apologize, but for those persons with the ability to opt out of Social Security, it can certainly be worth the involvement, even though it’s not a simple procedure.  If you’re among the fortunate ones who qualify, I advise you to seriously consider it.

I’ll conclude with a final thought.  There are those who accuse the government of running Social Security as a Ponzi scheme.  I consider this to be an insult to the memory of Charles Ponzi.  He never forced anyone to subscribe to his scam.

 

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