Categories
Personal Finance FAQ

Social Security – Neither Social nor Secure, But It’s Something

This is part of a series. If you have not read the articles that build up to this one, I recommend that you do so first.

In this article, we’ll examine strategies for when to take Social Security. Even though very few people can really rely on Social Security to provide them with the same standard of living that they had during their working lives, it still provides an income supplement for you when you retire that can have a dramatic effect on how much money you need to withdraw from your invested retirement assets. Getting this right can mean being better off by tens of thousands of dollars.

Social Security was developed as an insurance policy against running out of money when you got old. It wasn’t ever intended to be income replacement when you retired. The name of Social Security itself – Old Age, Survivors, and Disability Insurance (OASDI) – implies its purpose, which was to provide old age insurance.[1]

Thus, it will help you to think of Social Security in that manner; it’s meant to be a supplement to your other savings and investing which you’ve done throughout your working career. In 2014, the maximum amount of Social Security you could earn at a full retirement age – which we’ll define shortly – is $2,642 per month. To earn that, you would have needed to have a significant history of earnings in your work history. The Social Security Administration indexes earnings to present time. You can either look at the chart linked in this footnote,[2] or you can go to the Social Security estimator if you didn’t in “Retirement – Paying for Knee-High Socks and Hammocks.” It’s safe to say that many people won’t receive the full benefit. The estimated average benefit paid to a retired worker in 2019 is $1,477.01.[3]

Before we get into the details and strategies about Social Security payments, we need to define a few terms which the Social Security Administration uses.

First, there are three types of retirement benefits that you can receive:

  • Worker benefits: this is the payment that you receive as a result of your work history. In 2020, for each $1,360 of earnings on which you pay Social Security taxes, you will receive one credit. You can receive four quarters of credit per year. To qualify for retirement benefits, you need to have 40 qualifying quarters. The worker benefits are based on your 35 highest contributing years when you received income and paid Social Security taxes. You may start receiving worker benefits as early as age 62.
  • Spousal benefits: this is the payment that you receive as a result of being married to someone who is eligible for worker benefits or being a divorcee from a prior marriage of at least 10 years and not being remarried. This can be as high as 50% of the spouse’s worker benefits. You may start receiving spousal benefits as early as age 62.
  • Survivor benefits: this is the payment to a surviving spouse of the deceased spouse’s full benefits based on your age and if your spouse had already started receiving payments. The earlier you take benefits, if you’re below the full retirement age, or the earlier the spouse takes benefits, the lower the benefit will be. You must have been married for 9 months (unless you’re caring for a child of the deceased spouse who is under age 16) to receive survivor benefits. You can also receive survivor benefits from a deceased divorced ex-spouse if you are not married. You may start receiving survivor benefits as early as age 60.

There are three other key terms which you need to understand in order to grasp the full picture of how Social Security benefits work:

  • Full retirement age (FRA): This is the age at which you are eligible for full Social Security. Depending on your year of birth, this could be anywhere between age 65 and 67. It is the age at which there is no additional benefit for delaying receiving spousal or survivor benefits.
  • Primary insurance amount (PIA): This is the amount of worker benefits that you will receive once you reach FRA. As long as you’re working, the PIA could change, so if you’ve not reached age 70 and aren’t done earning wages or self-employment income, the number will be an estimate.
  • Delayed Retirement Credits (DRC): Think of the PIA at the FRA as your midpoint. If you take benefits before the FRA, then you will have your benefits reduced – 5/9% per month up to 36 months early and 5/12% per month beyond that, for a maximum reduction of 30% if you take the benefits at age 62 and your FRA is age 67. If you continue to delay after your FRA, though, you will receive 8% more per year (assuming your FRA is 66 or higher, meaning you were born in 1943 or later) up until age 70.

The reductions and increases in payments depending on when you take your benefits are designed to give you the same overall amount of money based on actuarial tables which take into account how long you’re supposed to live, assuming you can reinvest the money you receive. The reality is that with advances in medicine and with comparatively low guaranteed rates, where possible, delaying Social Security should provide a higher expected value than taking Social Security early.

Taxation of Social Security Benefits

It’s also important to know how Social Security benefits are taxed before deciding on a strategy for claiming the benefits.

There are two key thresholds to understand.

  Single Married Filing Jointly
< Threshold 1 0% taxable 0% taxable
Threshold 1 Income Amount $25,000 $32,000
  50% of earnings above Threshold 1 but not exceeding Threshold 2 added to combined income
Threshold 2 Income Amount $34,000 $44,000
  85% of earnings above Threshold 2 amount added to combined income

Your combined income is your Adjusted Gross Income on your tax return plus nontaxable interest (generally tax-exempt municipal bonds) plus, where applicable, the amount from above that you have to add from your Social Security benefits.

To calculate how much of your Social Security benefits get added to your Adjusted Gross Income, you take the lowest number from three tests:

  1. 85% of the Social Security benefits
  2. 50% of your combined benefits (Social Security + AGI + nontaxable interest) up to Threshold 2 plus 85% of benefits above Threshold 2
  3. 50% of your combined benefits (Social Security + AGI + nontaxable interest) above Threshold 1 plus 35% of the benefits above Threshold 2

Confusing, eh? That’s why I came up with a handy little calculator which does those calculations for you!

There are only three cells for you to fill in. In the first cell, you simply enter in if you are filing jointly. In the second cell, you enter in your total Social Security benefits (either yours if you’re filing single or married filing separately or yours and your spouse’s if you’re filing jointly). In the third cell, you enter in your AGI plus nontaxable income. The amount that appears in the fourth cell is the total amount that your Social Security benefits will contribute to your AGI. The amount that appears in the fifth cell is your total taxable income.

Below is a sample.

Since Social Security income contributes to the formula at only 50%, the combination that we discussed in “How to Save for Retirement” of withdrawing from tax-deferred IRA accounts early in retirement and delaying Social Security as long as possible has the effect of sheltering more Social Security income from taxation.

Let’s look at an example of how this works. Assume that the Smiths will both earn $2,000 a month in Social Security at a FRA of 66. They need $70,000 a year to live on between ages 62 and 70. If they claim Social Security at age 62, they will get $1,500 a month each. If they claim Social Security at age 70, they will each get $2,640 a month. This is how their taxation would differ at age 70 (disregarding cost of living increases).

Case 1: Claim Social Security early

Case 2: Claim Social Security later

In 2020, that would mean Case 1’s federal tax burden would be $7,556.25 and Case 2’s federal tax burden would be $1016.25, a difference of $6,540.00.

If you’re still working while you are claiming Social Security benefits and you are not yet at your full retirement age, then the Social Security Administration may reduce your benefits.[4]

If you don’t reach your FRA in the year

  • You can earn $17,640 gross wages or net self-employment a year and not lose any benefits in 2019.
  • The Social Security Administration will deduct $1 in benefits for every $2 earned above $17,640 in 2019.
  • If you reach your FRA during the year

    • You can earn $46,920 gross wages or net self-employment prior to the month you reach full retirement age and not lose any benefits in 2019.
    • The Social Security Administration will deduct $1 in benefits for every $3 earned above $46.920 in 2019.

    When to Claim Social Security

    If you can afford it, you’re best off delaying receiving benefits as long as possible because of the effective guaranteed return on your delay. It’s effectively 8% per year plus a cost of living allowance. Once you start taking benefits, you’ve locked in that purchasing power for the rest of your life.

    If you’re on the other end of the continuum, and you need your Social Security benefits to put food on the plate and a roof over your head, then take the Social Security benefits. Starving just to try to delay is pointless.

    For single people in the middle of that spectrum, it’s a matter of front-loading the tax-deferred IRAs as much as possible and delaying Social Security as long as possible. There are no special strategies for single people.

    For married people, there are multiple strategies involving a mix of worker benefits and spousal benefits.

    These strategies are dependent on at least one spouse reaching FRA before implementing them.

    If you need Social Security benefits and are not yet at FRA, then, if possible, claim the worker benefit of the lower of the two benefits and let the other continue to grow. This strategy will benefit both of you while you’re both living and will benefit the surviving spouse, since the higher amount will keep growing at between 5% and 8% until it’s claimed, and the surviving spouse will receive the higher of the two worker benefits upon death of the other spouse.

    Once one spouse, or both spouses have reached FRA, but before both reach age 70, there are two strategies which you can use for claiming Social Security benefits:

    • File and Suspend: Since you cannot claim spousal benefits until your spouse files for worker benefits, the higher earning spouse can file at FRA for worker benefits and immediately suspend the benefits, allowing the worker benefits to continue to gain DRCs while opening up eligibility for spousal benefits to the lower earning spouse. The lower earning spouse can still have his or her worker benefits gaining DRCs, and can later switch to worker benefits if that becomes a higher amount (preferably at age 70). Be sure to pay your Medicare Part B premiums out of pocket; otherwise, the Social Security Administration will act as if you’re waiving rather than suspending your benefit. Also, you need to be aware that spousal benefits have a 5% higher reduction prior to FRA than worker benefits do. The spouse who files and suspends cannot then claim spousal benefits. There is no point in waiting to file for spousal benefits after the younger spouse reaches FRA, as DRCs do not continue for spousal benefits past the FRA.
    • File a Restricted Application: This is a situation where the one spouse files for worker benefits. The other spouse then files for spousal benefits while still allowing the worker benefits to gain DRCs. This creates two sets of benefits: the worker benefit for one spouse and the spousal benefits for the other spouse. There is no point in waiting to file for spousal benefits after the other spouse reaches FRA, as DRCs do not continue for spousal benefits past the FRA. The upside to this strategy is that it allows both spouses to claim benefits; the downside is that it locks one set of worker benefits into a fixed purchasing power and eliminates further DRC growth.

    When both spouses reach FRA, there is no reason to not at least utilize the file and suspend strategy to claim spousal benefits. The higher earning spouse should file and suspend and allow the other spouse to claim spousal benefits. Between FRA and age 70, as a couple, you should at least be able to earn 50% of the higher spouse’s PIA in Social Security benefits.

    If you are a divorcee, there are special strategies as well, but only if you were married for 10 years before you divorced.

    There are two scenarios where you can use your ex-spouse’s benefits:

    • If you’ve not remarried. You can start taking spousal benefits as early as age 62, although the usual caveats for delaying taking the benefits because of DRCs through your FRA will apply. Your ex-spouse does not need to file for workers benefits for you to claim spousal benefits. If you remarry, you will lose the spousal benefits from your ex-spouse. If your ex-spouse predeceases you, then you will be eligible for survivor benefits. These benefits are available regardless of whether or not your ex-spouse remarries.
    • If you’ve remarried and become a widow(er). You are eligible to choose from the survivor benefits of any ex-spouse to whom you were married for 10 years or more if you are a widow(er) and predeceased the ex-spouse(s). This is how Joan Collins got to choose from so many survivor benefits options!

    As we’ve seen, choosing the proper Social Security benefits claiming strategy can have a big impact both on your overall benefits and on the amount of taxes which you pay on those benefits. It’s important that you plan properly and plan ahead, long before you reach the age of eligibility for Social Security.

    Now that we’ve looked at how to save for retirement and how to spend our money in retirement, our next articles will turn back to some other topics which will affect us in our financial lives before we reach retirement.

    [1] http://www.ssa.gov/history/genrev.html

    [2] http://www.socialsecurity.gov/pubs/EN-05-10070.pdf

    [3] https://www.ssa.gov/policy/docs/quickfacts/stat_snapshot/

    [4] https://www.ssa.gov/planners/retire/whileworking.html

    The next article in this series is Kids – Raising Them, Feeding Them, and Educating Them.

    By

    Jason Hull, CFP®, was the co-founder of Broadtree Partners, a firm that acquires $1-5MM EBITDA companies. He also was the co-founder of open source search consultancy OpenSource Connections, a premier Solr and ElasticSearch firm. He and his wife FIREd (financial independence retire early) at 46 and 45, respectively. He has a BS from the United States Military Academy at West Point and a MBA from the University of Virginia Darden Graduate School of Business.

    You can read more about him in the About Page.

    Leave a Reply