benefits impact the decision whether to apply at age 62, 66, or 70.
Editor’s note: From more than 500 articles published this
year, Horsesmouth members rated this article as one of the Top 10 of 2008. Read
some of your fellow advisors’ praise for this feature at the end of the
article—and add your own comments.
One of the most important decisions a retiree faces is when to apply for
Social Security benefits. This is not a decision to be made lightly; the
guaranteed lifetime inflation-adjusted income promised by Social Security makes
it one of a retiree’s most significant assets.
If you were to calculate the present value of a client’s Social Security
income stream, it would rival the lump sum many people have in their 401(k)
plans at retirement. While the Social Security “asset” may not be managed in the
traditional way, pre-retirees can enhance its value by building a strong
earnings record and applying for benefits at the optimal time.
The basic choices for applying for Social Security are these:
- Apply at age 62 and receive a reduced benefit for life
- Apply at full retirement
age and receive full benefits for life - Apply at age 70 and receive an additional credit for life
As full retirement age rises with the phase-in of 1983 amendments, the penalty for taking early
benefits is increasing while the credit for delaying the onset
of benefits is rising. These adjustments, combined with longer life
expectancies, are making it more and more advantageous for today’s retirees to
delay benefits to age 70.
For example, here’s what a 60-year-old client with $100,000 in earnings would
receive under the following scenarios:
| Social Security Payments at Different Retirement Ages |
||
| In today’s dollars | In future inflation-adjusted dollars |
|
| Apply in 2010 at age 62 | $1,507 | $1,640 |
| Apply in 2014 at age 66 | $2,071 | $2,522 |
| Apply in 2018 at age 70 | $2,822 | $3,874 |
The traditional way of deciding when to take benefits has been to calculate
the break-even
age. This is the age the client must live beyond in order for delayed
benefits to provide a higher lifetime income. Here are the break-even ages for
today’s 60-year-old:
| Break-Even Analysis | |
| Retirement ages considered | Break-even age |
| 62 vs. 66 | 76 years and 5 months |
| 62 vs. 70 | 79 years and 0 months |
| 66 vs. 70 | 80 years and 9 months |
However, it seems the break-even method of determining the onset of Social
Security benefits leaves out several factors that can influence the age at which
benefits should begin. A new paper titled “Rethinking
Social Security Claiming in a 401(k) World” highlights, among other things,
cost-of-living adjustments (COLAs), taxes, and spousal benefits. A key premise
of the paper is that today’s retirees face major risks in managing their
accumulated retirement funds, which generally end up in an IRA rollover account.
These include investment risk, longevity risk, inflation risk, and the financial
risk caused by the death of a spouse.
Two additional risks that are rarely discussed are expense risk and tax risk.
Authors James I. Mahaney and Peter C. Carlson argue that Social Security
benefits will become increasingly valuable due to their longevity protection,
inflation protection, survivor protection, and tax-favored status (only a
portion of benefits is taxable and only if income is over a certain threshold).
In light of the risks retirees face in managing their own retirement assets, it
behooves them to maximize Social Security benefits to the extent
possible.
COLAs
COLAs are the annual
increases in Social Security benefits that enable retirees to keep up with
inflation. In a low-inflation environment, they may not seem like much—2.3% for
2008, for example (compared with 14.3% in 1980)—but annual compounding creates a
snowball effect, making COLAs very significant over a person’s retirement years.
According to authors Mahaney and Carlson, most break-even analyses ignore the
impact of COLAs. But when COLAs are applied to the higher benefit available at
age 70, the breakeven age falls further. The longer a retiree lives, the higher
the lifetime benefit will be due to the impact of COLAs on the higher starting
amount.
Taxes
If a client retires at age 62 and has the choice of applying for early Social
Security benefits vs. delaying benefits and drawing income from an IRA rollover
during the “bridge period” (the years between retirement and age 70), many
advisors would recommend leaving the rollover intact (so it can continue to grow
tax-deferred) and taking reduced Social Security benefits to meet current
spending needs.
However, Mahaney and Carlson argue that when taxes are factored into the
formula, the opposite strategy is recommended. The reason is that taxes on
Social Security benefits raise the effective tax rate on whatever IRA
distributions the client does take. Since Social Security income counts at only
a 50% rate in the combined
income formula, much larger amounts of Social Security can be received
before the combined income thresholds are met.
They give the example of a 72-year-old retiree who has two options for
receiving pretax income of $69,000. In Strategy #1 he applied for early Social
Security benefits and now receives $24,000 per year; in Strategy #2 he delayed
benefits and now receives $39,000 per year. The balance of the $69,000 comes
from IRA withdrawals: $45,000 in Strategy #1 and $30,000 in Strategy #2. Because
the higher IRA withdrawals in Strategy #1 raised his combined income for the
purpose of calculating the income tax on Social Security benefits, more of his
Social Security benefits are taxed. Strategy #1 produces an after-tax income of
$61,703 vs. $65,321 for Strategy #2. Over a 30-year period the taxes saved in
Strategy #2 amount to more than $100,000.
Spousal benefits
When the combined benefits for a married couple are taken into consideration,
the analysis becomes much more complex. You must take into account each spouse’s
age, their combined life expectancies, the benefit based on each spouse’s own
earnings record as well as the spousal benefit (if higher), and the amount the
surviving spouse would receive after the spouse dies. Believe it or not, even
with all these variables, there are some rules of thumb that can help you advise
clients on when to apply for Social Security benefits.
For one thing, it’s important to know that spousal benefits may be taken by a
spouse who is at least 62 as soon as the primary worker reaches full retirement
age. However, benefits will be reduced if taken before full retirement age.
There is no advantage to delaying spousal benefits past full retirement age.
However, a primary worker need not apply for benefits in order for a spouse
to begin receiving spousal benefits. Under the Senior Citizens’ Freedom to Work
Act of 2000, a primary worker can “file and suspend” his own benefits upon
reaching full retirement age in order to initiate spousal benefits while
continuing to build delayed retirement credits for his primary benefit. Many
people do not understand this relatively new rule, but it can provide the
optimal solution for married couples where the spousal benefit (one-half of the
primary worker’s benefit) is higher than the benefit based on the lower-earning
spouse’s own earnings record and where the lower-earning spouse is younger than
the primary working spouse.
Of great significance is the survivor income protection this strategy
provides. If the primary worker dies first, the spousal benefit will drop off
and the spouse will begin receiving the primary worker’s benefit, made higher
due to the delay in the onset of benefits.
The authors conclude by saying that because of the additional benefits of
survivor protection, inflation adjustments, low expenses, and customization
options available, delaying Social Security (for at least one member of a
retiring couple) and taking income from personal retirement savings during the
bridge period becomes a very efficient strategy of providing retirement income.
Conversely, the rates of return required to be generated by personal savings
accounts such as IRAs and 401(k)s to pay for the additional taxes and management
expenses when choosing to take Social Security early exceed what many academics
and professionals are projecting today.
It is common sense, however, to always consider the health status of the
individual clients. Clients in poor health who are not expected to live past the
break-even ages should grab Social Security benefits while they can.
What advisors had to say
Here is some of the feedback advisors offered about this article:
- “Timely information. Great article.”
—Barbara G., New Alabany, Ind.
- “This topic is often raised by my clients and this article highlights
the many factors advisors must keep in mind to provide suitable advice.
Thanks!”—John S., Alexandria, Va. - “Excellent article. Helped clarify a few questions I had; I can now
better advise my clients. Thanks.”—Tim C., Frederick, Md. - “Love her articles—clear, well-written, and informative. Please keep
them coming!”—Catherine V., Winchester, Mass.
