Chapter 15. Social Security

According to the Social Security Administration (SSA), Social Security benefits represent about 40 percent of income for the elderly. Social Security benefits are guaranteed income that is inflation adjusted, investment risk-free, longevity protected, and comes with a spousal death benefit. Because the benefits are often a significant source of retirement income, it is important to know when to begin taking them to optimize lifetime benefits.

How Benefits are Determined

Benefits are determined based on a claimant's birth year, benefits start date, and lifetime earnings. Once reaching full retirement age (FRA), the worker is eligible for a full retired worker benefit, the primary insurance amount (PIA). Depending on the worker's year of birth, the current FRA ranges from sixty-five to sixty-seven. If a worker claims a benefit prior to reaching the FRA, the PIA can be reduced up to 30 percent. Due to delayed retirement credits, delaying a claim until seventy will result in a benefit of 32 percent over the PIA.

When to Take Benefits

Actuarially, if you live to average life expectancy, taking benefits at any age will provide the same cumulative amount of benefits. Under certain circumstances. you could earn more or less than what is expected. It is in these cases that deciding when to take benefits becomes important.

Factors to Consider

Current health, life expectancy, employment status, and taxes all affect the decision of when to take Social Security benefits. Most retirees are inclined to take them as soon as possible. However, the longer claiming is delayed, the greater the benefits. And larger benefits are beneficial to current retirees when longevity risk (living beyond life expectancy) is an issue.

Taking Benefits Early

The decision to stop working and start receiving Social Security at age sixty-two must factor in whether the individual can afford to live on the reduced benefits versus the higher benefits at age sixty-five. In addition, because an individual cannot qualify for Medicare until age sixty-five, they will be living on less income and have to find medical insurance to cover them the next three years. This insurance is likely to be expensive—if it can even be found.

For individuals in early retirement with no other significant income sources, taking benefits early may be the only option. If health problems force early retirement, consider applying for Social Security disability benefits as well. A qualifying retiree could receive a benefit equal to the PIA through a combination of early Social Security benefit and disability benefit. When reaching their FRA, the benefit will be converted to a full retirement age benefit.

Individuals who believe they have below average life expectancy should consider taking benefits as soon as possible. Some married couples might optimize household benefits by claiming early and collecting more survivor benefits overall.

If you take benefits early to supplement earnings income, $1 of benefits will be deducted for every $2 you earn above the annual limit. For 2010, the limit was $14,160. In the year you reach FRA, $1 of every $3 earned above $37,680 (annual limit for 2010) will be deducted from your benefits. This only includes the earnings in the months prior to reaching FRA. In effect, this creates a temporary 50 percent tax on earnings above the annual limit until you reach FRA, but a permanent reduction in Social Security benefit of up to 25 percent. Once you reach FRA, benefits have no limit on earnings. But this shouldn't completely discourage you from continuing to work while receiving Social Security benefits. The SSA automatically reviews your earnings record, replacing the lowest earnings in your work record with your latest year of earnings, if higher. If you have not already hit the maximum Social Security benefit, these higher earnings could result in a higher benefit.

Delaying Benefits

Delaying Social Security generally optimizes lifetime benefits. This is especially true for married couples due to additional benefits like spousal and survivor benefits. When a primary wage earner has a younger spouse with higher life expectancy, delaying benefits could pay off in the long run. Those who have the financial flexibility to delay until FRA or beyond will receive either the PIA or up to 32 percent over the PIA at age seventy. Delaying potentially offers these benefits:

  • Higher guaranteed annuity-like benefit with COLAs (cost-of-living adjustment);

  • Higher benefit paid to surviving spouse;

  • Higher benefit when maximum Social Security benefits have not yet been reached and a worker continues to work past sixty-two;

  • Avoiding the reduction in benefits if collecting Social Security and still earning income before FRA.

Taxes

If total income exceeds a certain level, up to 85 percent of Social Security benefits can be taxed as ordinary income. Social Security income is not taxed in the same way as IRA withdrawals: You can reduce your taxes by choosing higher Social Security income and lower IRA income when developing your strategy for taking retirement income.

To determine taxation of Social Security benefits, calculate your "Combined Income" —Adjusted Gross Income (AGI) + Non-taxable Interest + ½; of Social Security benefits. The Combined Income formula calculates the tax on the smallest of:

  • 50 percent of the excess over the first threshold (see Table 15.1 below), plus 35 percent of the excess over the second threshold; or

  • 85 percent of the benefits; or

  • 50 percent of the benefits plus 85 percent of any excess over the second threshold.

Table 15.1. 2009 Thresholds for Calculating Taxes on Social Security

 

Individual

Married

No tax

Less than $25,000

Less than $32,000

Up to 50 percent taxed

$25,000−$34,000

$32,000−$44,000

Up to 85 percent taxed

$34,001+

$44,001+

Here's an example of a married couple filing jointly:

AGI

$50,000

Tax-free bond interest

2,000

1/2; of $20,000 in Social Security benefits

10,000

Combined income

$62,000

Excess of income over 1st level ($32,000)

$30,000

Excess of income over 2nd level ($44,000)

$18,000

To calculate the new AGI on which taxes will be determined, take the smallest amount of the following:

Source: 2009 Mercer Guide to Social Security.

(A) 50% of excess over 1st level + 35% of excess over 2nd level

$21,300 (0.5 × $30,000) + (0.35 × $18,000)

(B) 85% of total benefits

$17,000 (0.85 × $20,000)

(C) 50% of total benefits + 85% of excess over 2nd level

$25,300 (0.5 × $20,000) + (0.85 × $18,000)

In this example, Option B is smallest. Income taxes will be calculated based on a new AGI of $67,000 ($50,000 + $17,000). So $17,000 (85 percent) of Social Security benefits will be taxed.

Is Social Security a Balance-Sheet Asset?

The Social Security benefit should be treated as an income stream reducing the need to take the risks required to achieve your financial goal. By reducing the need to take risk (by the amount of the benefit), the allocation to less risky fixed income assets can be increased and required allocation to riskier equity asset classes reduced. All pensions can be treated in the same way.

File and Suspend Strategy

The SSA offers three types of benefits for retired workers and their spouses:

  • Retirement Worker Benefit (RWB)—basic benefit determined by how long and how much an individual earns;

  • Spousal Benefit—benefit provided to a worker's spouse once the worker has claimed his/her own benefit. This can be up to 50 percent of the spouse's full RWB or PIA;

  • Survivor Benefit—benefit provided to surviving spouse after worker's death.

Using a File and Suspend strategy entitles the lower-earning spouse to a spousal benefit of up to 50 percent of the higher earning spouse's PIA. Additionally, the higher earner continues to work (or withdraw income elsewhere) to receive higher Social Security benefits at a later date, say age seventy. The File and Suspend strategy requires the higher-earning spouse to file at full retirement age (FRA) and immediately suspend benefits. This can be done at filing in the remarks section of the application, either on paper or online.

This strategy also benefits the couple in other ways. Should the higher earner die first, the surviving spouse would be entitled to a larger survivor benefit: the higher earner's delayed benefit. Essentially, the surviving spouse would get a step-up in benefits to 100 percent of the spouse's delayed benefit. By delaying benefits, the couple could also begin to draw down on the IRA for supplemental income. This both reduces the balance of the IRA and future required minimum distributions (RMDs) and can minimize the amount of future Social Security benefits that will be taxed.

Here's an example (see Table 15.2) in which the husband is the higher earner. The husband is sixty-six, his wife sixty-five. Using the file and suspend strategy, the husband files and suspends his benefits at age sixty-six ($2,000 per month). His wife files for half of her husband's PIA ($1,000 = $2,000 × 50 percent) at her FRA (or earlier but with a reduced benefit). The husband continues to work and draw additional income from his IRA to reduce future RMDs and delay claiming social security until age seventy. At age seventy, his monthly benefits will be $2,640. Should the husband die first, the wife would get a step-up in benefits, receiving the survivor benefit of $2,640 instead of $2,000 (had the husband filed and claimed benefits at his FRA).

If the husband dies at age eighty-three and the wife at eighty-five, the two Social Security income streams would look like this:

Table 15.2. File and Suspend

 

Both claim at 66 (FRA)

File & suspend (until 70)

(1) Calculations do not take into consideration taxes, COLA adjustments, or present value assumptions

(2) Calculations do not take into consideration taxes or COLA adjustments. Uses TIPS yield with maturity equal to life expectancy to discount cash flows through life expectancy as of February 25, 2009.

Husband benefit at 66 (FRA)

$2,000

N/A

Spousal benefit at 66 (FRA)

$1,000

$1,000

Husband benefit at 70

N/A

$2,640

Survivor benefit

$2,000

$2,640

Total SS benefits received (1)

$732,000

$871,920

Net present value of total SS benefits received (2)

$590,422

$683,521

In summary, the File and Suspend strategy potentially allows for:

  • The higher-earning spouse to delay benefits in order to receive a payment of up to 32 percent higher than the PIA.

  • The lower earning spouse to become eligible for the spousal benefit before the higher-earning spouse begins taking claims.

  • The lower-earning spouse to receive a larger survivor benefit equal to what the higher-earning spouse was receiving or entitled to.

  • The reduction of RMDs by taking withdrawals from IRAs when needed prior to claiming benefits at age seventy, potentially keeping more Social Security benefits tax-free.

Due to longer life expectancies for women, this strategy works best for couples in good health where the husband was the higher income earner. If one of the spouses is in poor health or there is an immediate need for income, benefits should not be delayed. Alternatively, if there is a need to preserve the IRA because valuations are down and withdrawals should be delayed, Social Security benefits could be taken early. While the husband should wait to take delayed benefits, the wife can take benefits early and not significantly reduce the total amount of benefits the couple will receive. To determine the best strategy on optimizing lifetime benefits, call the SSA and find out what each spouse's estimated benefits will be at age sixty-two, sixty-six (or FRA), and seventy.

Double Dipping Strategy

Qualified nongovernmental workers can elect both a spousal benefit and worker benefit at different points in time during retirement: the "double dipping" strategy. This strategy most benefits married couples where both spouses have had similar lifetime earnings, but it can be applied to any dual-income couple.

If an individual qualifies for both benefits at the time of filing, the Social Security office will assume the claimant is filing for both benefits simultaneously. In that case, the individual will only receive the higher of the two benefits. To prevent this, you need to clearly state on the application which benefits are being claimed.

While an individual can elect to take the retirement worker benefit (RWB) any time after age sixty-two, the spousal benefit can only be taken after the spouse files for benefits. Furthermore, in order to "double dip," an individual must file for the spousal benefit at FRA in order to take their own RWB at a later date.

Which benefit to claim first primarily depends on the actual amount of each benefit. The amounts depend on how much the individual and their spouse earned and the ages at which they decide to claim. Let's take a case where a married couple, John and Mary (both sixty-two years old), have the following monthly social security benefits (see Table 15.3):

Table 15.3. Double Dipping

 

62

FRA

70

John's RWB

$1,600

$2,000

$2,640

Mary's RWB

$880

$1,100

$1,452

Mary's spousal

$700

$1,000

n/a

Filing for a spousal benefit would entitle Mary to a benefit of $1,000 at FRA. On reaching age seventy, Mary could then file for her own RWB, increasing her benefit to $1,452.

Double dipping is not gender-specific: Whichever spouse is the lower-income earner can employ the strategy. If the spouses are close in age, both can take advantage of double dipping. Note that while the SSA allows this strategy, not all SSA officers are familiar with it. Be sure you talk to your Social Security benefits adviser prior to filing to clearly plan out your Social Security claiming strategy.

Summary

Individual circumstances drive the decision on when and how to take Social Security benefits. For those having the financial flexibility to defer benefits, higher annual benefits and other potential benefits like higher spousal and survivor benefits and longevity insurance generally make it more beneficial to defer. You may want to consult with a financial adviser or at least call the SSA and find out what you and your spouse's estimated benefits will be at age sixty-two, sixty-six (or FRA), and seventy.

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset
18.117.233.26