This close to Tax Day everybody is talking about taxes. And one of the taxes that commentators love to complain about most is the Social Security tax. Why? Well, other than the usual gripes, the biggest complaint about Social Security seems to be that it is regressive – in other words, that it hits lower-income individuals harder than those who earn more. Like many things in the world of taxation, however, appearances can be deceiving. And I certainly think that they are deceiving in the case of Social Security taxation.
Social Security payments, unlike most other government collections, do not simply go into a fund to pay for government services and whims (and to help get current politicians reelected). If you pay into Social Security you in fact get something in return. That something is a promise of future benefits. Though its mandatory nature can make Social Security contributions feel like other taxes, in financial terms Social Security’s system of credits and delayed benefits makes it much more like a deferred annuity than like a run-of-the-mill tax. If we consider Social Security contributions in this light – as an investment – we come to an interesting conclusion.
Seen as an investment, the Social Security system is already rigged in favor of lower-income investors and against higher-income investors. That is because payments based on earnings up to approximately the first 10% of Social Security’s wage base entitle the participant to a future monthly payout roughly equivalent to 90% of that amount, adjusted for wage inflation. Payments based on the next 47% of your Social Security wages yields only a 32% wage equivalent. And the highest 43% gets you a paltry 15% wage replacement. As a result, if your average annual lifetime earnings are around $35,000, your Social Security payment at full retirement age will be (roughly) $16,685, or almost half (48%) of your pre-retirement salary. On the other hand, if you paid in on the maximum wage base (currently $110,100) your entire career, your Social Security payment would replace only 28% of your average annual earnings ($31,336). In other words, Social Security gives low-income earners a much higher return on their investment – up to twice as much, in fact – than it gives to high-income earners. So much for the argument of regressivity.
Maximize The Return On Your Social Security Investment
Despite the structure that favors lower-income participants, however, Social Security offers significant advantages to higher-income individuals. What’s more, there are a number of ways in which all participants in the system can maximize the benefits that they are likely to receive.
Unfortunately, many affluent families overlook the benefits to be gained by good Social Security planning. But even though the cards may be stacked against you, you can maximize the returns on your Social Security investment by following some pretty straightforward rules.
Work Longer; Earn More
Since Social Security benefits are based on your highest 35 years of (indexed) earnings, many higher-income participants can benefit by strategically adding to their earnings record, especially in the years between their “full retirement age” (FRA) and the time when they fully step back from earning a paycheck.
A detailed knowledge of your personal earnings record is crucial in order for this strategy to be effective. If you have paid in based on the maximum Social Security wage base for 35 years or more, then you have nothing more to gain by continuing to pay into the system. Many affluent earners, however, spent a long time in school or went through job transitions that lowered their annual earnings for several stretches during their careers. This can result in shortened earnings records at full retirement age (FRA) – which is 66 for most Boomers – or of several years of earnings that are far below the Social Security maximum. Such individuals can significantly improve their eventual payouts by continuing to build their Social Security earnings record by continuing to work for several years after their full retirement age.
For many, this option also fits in nicely with plans to transition into full retirement. For many affluent workers, the goal of earning the Social Security maximum – $110,100 this year – represents far less than they would earn in a typical year of full employment. So they can still work part time or consult or even switch careers and still attain this income level.
For couples who own small business, there is another interesting possibility. If one party (the husband, for example), has already fully funded his Social Security record, the couple can consider shifting both responsibilities and income to the other spouse, thus bolstering her eventual return without changing family income or overall cost.
Apply At The Optimal Time
In their rush to retire as early as possible, many individuals don’t realize that the choice to receive Social Security benefits prior to their full retirement age permanently reduces their monthly payout from the system by as much as 25%. Further, because Social Security COLAs (cost of living increases) are based on one’s initial payout amount, the difference between the two options actually increases over time. Similarly, many participants fail to consider that they can increase their monthly payment by as much as 33% by waiting until after their full retirement age and earning “delayed credits”. Thus the option to delay the onset of Social Security payments until age 70 is one of the most powerful tools available to enhance one’s lifetime returns from Social Security.
Many people opt to begin receiving Social Security payments as soon as possible out of a fear that the system will stop paying benefits altogether later on this century. Their idea is to grab as much money as possible as quickly as they can. But I believe that those fears are overblown. First, though it is true that actuarial calculations show that the current system of transfer payments will only be able to sustain about 77% of the system’s currently projected benefits by mid century, Boomers who are currently 55 or older are the least likely to be affected by any future changes. Moreover, if benefits to the already retired are reduced, that change is likely to hit all retirees of the same age equally. Accepting a low initial payment will not assure you of avoiding a reduced benefit in later retirement.
For most retirees, however, a much greater risk is the possibility of running out of cash before one runs out of retirement. This makes a robust Social Security income stream particularly valuable. You can never outlive your Social Security payments and, unlike many other pensions and annuities, they will continue to increase with inflation. Thus, for most people, waiting in order to maximize their eventual Social Security payment stream is the single most effective way they have of insuring that they won’t run out of cash in retirement.
But what about the possibility that you’ll die before you’ve received all the benefits you’re counting on? Naturally, there are instances where the best strategy is to take advantage of early payment options, especially if one’s life expectancy is short for medical reasons. That is why these decisions need to be made in the context of one’s individual circumstances. That said, however, most retirees will be best served by waiting. The retiree who waits until full retirement age to begin payments will overtake his early-retiring counterpart in terms of cumulative benefits by the age of 74 on average. And the lifetime benefits of those who choose delayed benefits will surpass all others by the age of 79.
Coordinate Spousal Benefits
Social Security offers generous benefits to spouses (gender neutral), including divorced spouses. At full retirement age, the spousal benefit for a married individual is 50% of the participant’s “primary insurance amount”. PIA is a technical concept that is too involved to delve into here, but it generally reflects one’s Social Security payment calculated at full retirement age. If a spouse files for benefits as early as 62, that benefit is reduced to 35% of the primary insurance amount. As a general rule, a participant must file for benefits in order to enable his/her spouse to file for a spousal benefit. However, if the participant files at full retirement age or later, he (or she) can opt to suspend his own benefit and continue to earn delayed credits. On the other hand, there is no such thing as delayed credits for spousal benefits. These same general rules apply to divorced spouses, as long as the marriage lasted 10 years or more and the recipient is currently unmarried.
Many affluent couples are dual-income couples. This means that both spouses have the choice of claiming either a spousal benefit from Social Security or of applying on their own record – sometimes both. In practice, given spouses of different ages and earnings histories, the possibilities for benefits coordination are frequently a complex and need to be analyzed on an individual basis. In general, however, there are two approaches that are worth noting here.
The first is the “file and suspend” strategy. In this case a high-earning spouse (the husband, for illustrative purposes) files for his Social Security benefit at full retirement age (66) in order to enable his wife to receive her full spousal benefit. He then suspends his own benefits until age 70 in order to earn the maximum amount of delayed credits possible. Since the wife cannot earn delayed credits on her spousal benefits, the family maximizes their long-term potential benefits by beginning her spousal benefits at her full retirement age.
The second approach worth mentioning is called “claim now, claim more later”. In this approach, a high-earning wife files for a spousal benefit based on her husband’s earnings record. (The husband must have filed for his own benefit at full retirement age.) She then switches to her own benefit at age 70, having earned delayed credits in the intervening years, and possibly having improved her earnings record as well.
The actual benefits increase from such approaches depends on the specifics of each couple’s individual circumstances. But in the best cases it can total tens – or even hundreds – of thousands of dollars and is worth considering in advance.
Maximize Survivor Benefits
In general, if both spouses are receiving Social Security benefits and one spouse dies, the remaining spouse will “inherit” the higher of the two benefits, but lose the second benefit. (Remarriage before age 60 disqualifies a widow(er) from receiving survivor benefits, since it is assumed that she will be able to rely on her new spouse for spousal and survivor benefits.)
Given that many women outlive their husbands, maximizing the survivor’s income benefit can make a significant difference in her (or his) eventual financial circumstances. In general, therefore, the best approach is to maximize the benefit of the higher-earning spouse. It is also generally best to resist the temptation to apply early (age 60) for survivor’s benefits, since this permanently reduces the benefit to 71.5 of the primary insured’s PIA. A wife with a modest earning record on her own can apply for an early benefit to help bring in some cash and then switch to spousal benefit at full retirement age.
Minimize Taxes On Benefits
Finally, as always, it’s not just what you make that matters; it’s what you keep. For many affluent individuals and couples, 85% of your Social Security benefits will be taxed no matter what. There are circumstances, however, in which you can influence the taxation of benefits.
One approach is to manage the amount of income you take (and need) in retirement, especially in the crucial years between 65 and 75. For example, if you’re planning on waiting until 70 to begin your Social Security benefits, you may want to start drawing down on your regular IRA accounts in your late 60s in order to minimize the size of your eventual required minimum distribution (RMD), beginning after age 70 ½. That way you’re more likely to stay in a lower tax bracket once your Social Security benefits kick in.
Another option that could work for some is to minimize the need for retirement income by paying down debt and adopting a simpler lifestyle. After all, if you don’t need the income, you’ll have less of a need to generate taxable income by drawing down on your pre-tax retirement accounts. You can supplement your Social Security payments with withdrawals from your taxable accounts and keep your overall tax bill to a minimum.
Finally, you may want to use the years between semi-retirement and the onset of Social Security benefits to convert some or all of your IRA funds to Roth IRAs. True, you’ll need to pay the tax bill up front, but subsequent withdrawals from those accounts will not only be tax-free, they may also minimize the taxation on your Social Security income under $44,000.
Do Your Homework
All the rules-of-thumb in the world are no substitute for an analysis of your specific situation. Individuals and couples nearing retirement should understand that the decisions they make with regard to their Social Security benefits are among the most important they’ll make in securing their long-term financial goals. If you have questions regarding your own retirement plan, we’re here to help.