If you are confused by the advice some people are offering about Social Security benefits, you're not alone. In perhaps no other area of personal finance is more misinformation consistently provided. As a result, people often make the wrong decision about when to start receiving their Social Security benefits. This article aims to set the record straight.
Sources of Information About Social Security
Let's begin with some general guidance. As you approach age 62, the earliest age at which Social Security retirement benefits can begin, you are entitled to free counseling from your local Social Security office. While the quality of this counseling is generally good, it can vary in depth and clarity depending on the knowledge and experience of Social Security employees.
The definitive place for clear, accurate information is the Social Security Administration's comprehensive website. Once you are there, most of what you will need is located under the "Retirement" menu. The goal of this article is not to replace information from the Social Security Administration (SSA), but merely to summarize key points while focusing on and correcting common misconceptions. (For basic information about Social Security, read Introduction To Social Security and Ten Common Questions About Social Security.)
Myth No.1 - It's usually a good idea to start receiving Social Security benefits at age 62, as soon as you become eligible.
There are two schools of thought behind this idea. The first is that even if you do not need the money to cover your living expenses, you should take it so that it can be invested. Assuming you can invest the money successfully, you then may have more money available down the road than if you waited until full retirement age to start receiving benefits. (Note: For most people who will retire over the next decade, full retirement age is 66.)
The second school holds that a bird (or benefit in this case) in the hand is worth more than two in the bush. The theory states that you should take every dollar as soon as you can because Social Security retirement benefits (at current levels) may not continue much longer. This concept is based on a fear that Congress will scale back benefits to strengthen funding.
Reality - When to start Social Security is a complex decision that should be personalized for each individual, and it can involve many factors, ranging from the potential to continue working, to attitudes about longevity and inflation. Permanent reductions for starting benefits before full retirement age are assessed on a monthly basis, so there is no hurry to make the start-date decision. By waiting to start until three months after age 62, for example, you can avoid three months' worth of permanent benefit reductions. Clearly, individuals have different levels of confidence in their ability to "invest the difference" successfully. Some people don't want the extra pressure of having to invest critical retirement assets in uncertain markets.
As for the fear-based argument, Social Security benefits are not guaranteed, and Congress can make any future changes it wishes. But for both practical and political reasons, it may be more difficult to reduce the benefits of retired people who have already earned them by formula. There are two important ages for this purpose:
- At age 60, your average indexed monthly earnings (AIME) are calculated, including the final year of indexing to the National Wage Index.
- At age 62, individuals qualify for a primary insurance amount (PIA), which is their benefit payable monthly at full retirement age.
The SSA has a significant investment in technology and counseling resources behind these calculations, and individuals age 60+ rely on them for retirement-planning security. So, even if Congress should decide to reduce benefits, it could grandfather anyone who has already reached age 60 or above. (For more on the AIME and PIA, see How Much Social Security Will You Get?)
Myth No.2 - If you don't start receiving Social Security benefits early, you must wait X years to "break even."
You may hear some financial pundits make claims such as: "Your breakeven age for starting Social Security benefits is age 77." By this, they mean: If you were to start benefits at age 62 instead of waiting until full retirement age, you would have more money in hand (on a time-weighted basis) through age 77.
Reality - There is no universal breakeven age, because the variables behind the calculation can change. They include:
- the discount rate or time value of money,
- the inflation rate, and
- whether the benefit recipient is a worker or non-working spouse.
The permanent benefit reduction for starting early is greater for non-working spouses than for workers. Therefore, most non-working spouses can expect to outlive their breakeven ages You can also think of the discount rate or time value of money as the after-tax return you could earn by investing after-tax Social Security benefits from age 62 through full retirement age. However, keep in mind that up to 85% of benefits may be taxable for high-income seniors. (To learn more, read Understanding The Time Value Of Money.)
Finally, the breakeven point usually isn't the most critical issue in making the start-date decision. If you don't need the income to support your lifestyle from age 62 through 66, it's often best to wait. (See the Social Security Administration's Breakeven Calculator for more information.)
Myth No.3 - If you keep working after you start Social Security benefits early, you could permanently lose part or even all of your benefits.
In 2013, Social Security currently reduces benefits by $1 for every $2 of earned income above $15,120. This reduction continues until the start of the year in which you reach full retirement age.
Reality - It's true that your benefits are reduced if your earned income exceeds a threshold. For example,assume that you work and earn $23,120 ($8,000 over the $15,120 limit) in 2013. Your Social Security benefits would be reduced by $4,000 ($1 for every $2 you earned over the limit), but you would still receive $5,600 of your $9600 in benefits for 2013. ($9,600 - $4,000 = $5,600)
Some commentators say that it is wasteful to start benefits early and then continue to work and lose benefits for several years. However, this is not so. Any benefit reductions are only deferred, and Social Security will credit those amounts to your benefits record when you reach full retirement age. There are good reasons not to start benefits before full retirement age, but this one isn't high on the list. (To learn more, read Stretch Your Savings By Working Into Your 70s.)
Myth No.4 - If you keep working after full retirement age, you will keep paying FICA into the system but you won't earn any more Social Security benefit credits.
Most workers and their employers are subject to the Federal Insurance Contributions Act (FICA) withholding on earned income, regardless of the worker's age. Self-employed people pay the same rate in self-employment (SE) tax. The total FICA withholding or SE tax for 2013 is 13.3%, up to $113,700.
Reality - Every dollar of earned income, up to any age, can result in increases in Social Security benefits. Social Security will automatically recalculate your primary insurance amount (PIA) every year in which you work. If one of your 35 highest indexed-earnings years is attained after you start benefits, then you will be credited with a higher benefit. However, you do not receive any help from annual wage indexing after the calculation made in your 60th year. As long as you keep paying FICA or SE taxes, however, you can potentially keep increasing your benefit. There is no disincentive in the Social Security system to keep working after you start benefits.
Myth No.5 - The tax on Social Security benefits isn't enough to worry about.
Modestly affluent seniors now pay tax on up to 85% of benefits. For example, an affluent senior has 85% of a $20,000 annual benefit taxed at a 25% marginal federal tax rate. The tax on benefits is $4,250 ($20,000 X .85 X .25).
Reality - There are two problems with discounting the tax impact on benefits. First, it is possible and perhaps likely that the taxable portion could increase to 100% in the future as a politically attractive way to strengthen the system's fiscal status. Secondly, because benefits are paid monthly, they offer little tax-planning flexibility, unlike many other sources of retirement income such as Traditional IRA withdrawals prior to age 70.5.
Tax impact should definitely be considered in making Social Security decisions. In the example above, if 100% of benefits were taxable at 28%, instead of 85% at 25%, the tax would increase to $5,600, an increase of $1,350. (For more information on retirement income taxation, read Five Tax(ing) Retirement Mistakes and Avoid The Social Security Tax Trap.)
Myth No.6 - Social Security benefits don't really help seniors offset inflation.
This myth arises from a lack of understanding about how Social Security's annual cost of living adjustment (COLA) works. Also, it may involve a belief that retired people have better inflation-hedging tools available to protect their retirement incomes.
Reality - The COLA is perhaps Social Security's most powerful long-term planning benefit. For an 85-year-old person who started benefits 20 years ago, cumulative COLAs now provide more benefit than the starting benefit itself. Each year, all Social Security retirement benefits are adjusted dollar-for-dollar for Consumer Price Index (CPI) inflation, creating a direct offset against inflation (as measured by this index). (For more on the COLA and how it helps counter inflation, read Maximize Your Social Security Benefits.)
For many retired people, the COLA provides the only source of inflation-adjusted retirement income linked directly to the CPI. A similar benefit is available only in some types of immediate annuity and pension payouts. For individuals who don't receive income from immediate annuities or pensions, maximizing Social Security benefits can be one of the best ways to hedge retirement income against high inflation.
For individuals who live a very long time, any decisions to start benefits early at permanently reduced levels will reduce the longevity protection of lifetime benefits and the inflation protection of the COLA. Therefore, individuals who are in good health and have "longevity genes" in their families should carefully consider the long-term cost of starting benefits early. Keep in mind that the current COLA is not guaranteed and could be changed by Congress in the future.
In summary, knowing the reality about your Social Security benefits can be valuable in making sound choices - especially about when to start benefits and how to maximize their longevity and inflation protection. If you are still in doubt about the particulars, take the time to study the wealth of current information available from the Social Security Administration's website.