Medicare and Social Security funding: FICA taxes and trust funds, explained
Medicare and Social Security, two cornerstones of the American social safety net, provide income and health insurance for retirees and individuals with disabilities.
Both programs are massive in terms of size and cost. In 2023, the Social Security Administration paid out over $1.4 trillion in benefits to more than 73 million recipients. Medicare wasn’t far behind, with total program spending hitting $944.3 billion in 2022.
But how exactly are Medicare and Social Security funded? And are these programs at risk of running out of money in the future?
Here’s what you need to know.
FICA Taxes
The primary source of funding for both Medicare and Social Security comes from payroll taxes. These taxes are deducted directly from your paycheck before you receive it. This system is facilitated by the Federal Insurance Contributions Act (FICA), which requires contributions from both employees and employers.
Here’s a breakdown of FICA taxes:
Social Security tax: Both you and your employer contribute 6.2 percent of your wages up to a capped amount called the taxable maximum ($168,600 in 2024). This cap means that high-income earners don’t pay Social Security tax on any income that surpasses the limit.
Medicare tax: Another 1.45 percent is deducted from both your paycheck and your employer’s contribution. This tax goes towards funding Medicare.
If you are self-employed, you’re responsible for the entire FICA tax, meaning you pay both the employee and employer share, totaling 12.4 percent for Social Security and 2.9 percent for Medicare.
Trust funds
Money collected through FICA taxes isn’t directly funneled into Social Security and Medicare benefits. Instead, it’s deposited into dedicated trust funds created by Congress and managed by the U.S. Treasury.
Any surplus money within the trust funds is typically invested in special Treasury bonds, generating interest that further contributes to the program’s financial stability. By keeping the collected FICA taxes in these trust funds, the system ensures money is available for current beneficiaries.
Medicare trust funds
There are two main Medicare trust funds:
Hospital Insurance (HI) Trust Fund: This fund pays for Medicare Part A benefits, which cover inpatient hospital stays, skilled nursing facility care, hospice care and some home health services.
Supplementary Medical Insurance (SMI) Trust Fund: This fund finances Medicare Part B benefits, including doctor visits, outpatient care, durable medical equipment and other medical services. The fund also helps cover administrative costs of the Medicare Part D program, which offers prescription drug coverage through private insurance companies.
Medicare Part A is premium-free for most beneficiaries because the program is funded primarily through payroll taxes. So long as you worked for at least 10 years and paid into the system, you can qualify for premium-free Part A.
Medicare Part B, on the other hand, charges beneficiaries a standard monthly premium of $174.70. While Part B premiums cover about 25 percent of program costs, general revenue subsidies cover the remaining expenses.
Social Security trust funds
Social Security also utilizes two trust funds:
Old-Age and Survivors Insurance (OASI) Trust Fund: This fund disburses benefits to current retirees and survivors receiving Social Security payments.
Disability Insurance (DI) Trust Fund: This fund provides financial support to those currently receiving Social Security disability benefits.
In 2022, the Social Security trust funds collected $1.22 trillion in revenue. Of that, about 90 percent came from payroll taxes and 4 percent came from taxes collected on Social Security benefits. Interest earned on government bonds held by the trust funds provided the remaining revenue.
When you pay Social Security taxes, that money isn’t earmarked with your name on it inside the trust fund. Instead, most of the payroll taxes collected from current workers are used to pay benefits to current recipients.
The combined OASI and DI Trust Funds provide a financial cushion for Social Security, ensuring benefits are paid even during revenue shortfalls. However, the aging population and declining birth rates have raised concerns about the long-term solvency of these trust funds.
Future outlook for Medicare and Social Security funding
Both Medicare and Social Security face financial challenges in the coming years, mostly driven by changing demographics and rapidly rising health care costs. The depletion of trust funds for Medicare Part A and the potential exhaustion of the Social Security trust funds have sparked controversy and debate among lawmakers in Washington for years.
The latest projections from the Social Security Trustees indicate that the combined OASI and DI Trust Funds are expected to be depleted by 2034. Once depleted, ongoing payroll tax revenues would be sufficient to cover only 80 percent of scheduled benefits.
For Medicare, the impact could also be significant. The Hospital Insurance Trust Fund will be able to pay all scheduled benefits until 2031, according to the Social Security and Medicare Boards of Trustees 2023 Annual Report. Once depleted, ongoing payroll tax revenues would be sufficient to cover 89 percent of scheduled benefits.
Congress has floated numerous policy proposals over the years to help shore up these financial shortfalls, though any changes have yet to materialize. Some proposals include:
Reducing benefits: This could involve decreasing benefits for Social Security recipients, reducing Medicare coverage for certain services or tweaking how benefits for both programs are calculated. Here’s how Social Security benefits are currently calculated.
Payroll tax increases: Increasing payroll taxes that fund Social Security and Medicare is another option. The last time the Social Security tax rate increased was 1990 and the Medicare tax hasn’t increased since 1986, according to the Tax Foundation.
Creating a new trust fund: Instead of investing in special Treasury bonds, which have a relatively low rate of return, some lawmakers have proposed creating a new trust fund that uses a market-based investment strategy and invests in stocks or passive index funds to help generate higher returns.
Entitlement reform: A broader approach involves changes to the overall structure of the programs to maintain long-term solvency, such as raising the full retirement age for Social Security (currently age 67 for those born in 1960 and later) or raising Medicare’s eligibility age (which has remained age 65 since the program was created in the mid-1960s).
The Supplemental Medical Insurance Trust Fund (which funds Medicare Part B) isn’t at risk of running out of money like the other trust funds. That’s because its main financing sources — Part B premiums from beneficiaries and federal contributions from the Treasury — are automatically adjusted each year to cover costs for the upcoming year. However, rapidly rising health care costs “have been steadily increasing demands on beneficiaries and general taxpayers,” according to the Board of Trustees’ annual report.
Bottom line
Payroll taxes, trust funds and other revenue streams work together to provide financial security for millions of Americans. However, Medicare and Social Security face significant fiscal challenges moving forward.
Even if you’re young, Social Security and Medicare solvency is important. You’ll likely rely on these programs in the future, so it’s important to understand how they’re funded in case lawmakers make changes in the years ahead.
