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Shrinking Social Security

A new report says Social Security will replace less of your income than it did before, thanks to taxes, Medicare and the reality of hitting your 60's.

By Jeanne Sahadi, CNNMoney.com senior writer

NEW YORK (CNNMoney.com) -- Since few of us actually like to save, here's some incentive: a new study says Social Security will replace much less of your pre-retirement income than it has for retirees in the past.

To give you an idea of what that means to your wallet, consider a 65-year-old average earner making, say, $36,000 the day he retires. He might get about $14,000 in Social Security benefits after paying his Medicare premiums today. But if it were 2030, that same earner would pocket closer to the equivalent of $10,000. And the more you earn, the greater the difference would be.

What you need to save
2007 Social Security benefits
For earners who average: Benefits at age 65: % of pre-retirement income
$16,700: $9,400 54%
$37,200: $15,570 40%
$58,900: $20,610 34%
$87,800: $24,000 28%
Source:The National Academy of Social Insurance based on data from Social Security Board of Trustees

That assumes he retires at 65 and earned a paycheck for at least 35 years. In reality, though, a lot of retirees don't meet those criteria and end up with a smaller Social Security check, according to a report Monday from the National Academy of Social Insurance (NASI).

That's because many retire at 62 - some by choice but many because they lost a job or can't work due to illness or injury. Women in particular tend to have fewer years in the work force since they may take time out to care for children and parents.

Over the next 25 years, NASI says, the amount of pre-retirement income replaced by Social Security is expected to fall for a number of reasons:

More retirees will have to pay income tax on their Social Security benefits. In 1983, lawmakers decided retirees whose total income was at least $25,000 (or $32,000 for those filing jointly) would have to pay income tax on a portion of their benefits. Those income levels are not adjusted for inflation.

Also, while Social Security payments are adjusted for cost of living every year, Medicare premiums, which are paid out of your Social Security check, have been rising faster than inflation.

Finally for those born in 1960 and beyond, the retirement age is 67 - the age when new retirees would be eligible for full Social Security benefits. So if a worker has to retire earlier and start collecting benefits - as many do - that will reduce his monthly paycheck.

For example: In 2005, the average 65-year-old earner who retired got a Social Security check that replaced 39 percent of his pre-retirement income after accounting for Medicare premiums. His total income wasn't high enough to subject his benefits to income tax. But by 2030, it will be.

So after deducting Medicare premiums and income taxes on a portion of his benefits and taking a reduced Social Security benefit because he retired two years before his full retirement age (67), Social Security will only replace 29 percent of what he used to earn.

As a supplement to personal savings (and a pension if you're lucky enough to have one), Social Security checks can make it much easier to generate 80 percent of your pre-retirement income when you retire. But if the past is any guide, many people will rely heavily on Social Security, which currently accounts for half or more of the retirement income of 60 percent of retirees, according to NASI.

Research is being conducted to come up with an Elder Economic Security Index for each state to reflect what retirees need to meet basic needs. In Massachusetts researchers found that to afford housing, food, health care, transport and personal items, a person would need income equal to 150 percent to 300 percent of poverty level, which is $10,210 for individuals and $13,690 for couples.

With an expected swell in benefit-eligible retirees in the next 20 years, increased life expectancy, and a Social Security trust fund the government may have to go into debt to repay, actuaries and pension experts have been calling for changes to bolster the system's long-term funding. It's a debate that has been put on hold for now.

For those in their 20's, 30's and 40's, you can bank on this: whatever changes are decided, you'll either end up paying more for the benefits promised or you'll receive less of them, or, possibly, both.

Or you could just move to Luxembourg. According to data in NASI's report from the Organization for Economic Cooperation and Development (OECD), retirees in the tiny European nation get Social Security-like benefits that equal 100 percent or more of their pre-retirement income, ranking it No. 1 among all 30 member countries of the OECD, many of which fund government retirement benefits with contributions from workers, employers and general taxes, with typically higher tax rates than in the United States.

By contrast, the U.S., where Social Security benefits are funded only with money from workers and employers, ranks in the bottom 10. Top of page

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Did you retire by age 50 through hard work and smart planning to spend your time pursuing a passion or hobby? Living in the midwest or south? Tell us your story for an upcoming feature in Fortune Magazine. Send e-mails to chajim@fortunemail.com.