Alan M. Schapire, CPA, PFS, CFP | Sep 03, 2015
Tens of millions of Americans currently rely on Social Security benefits to provide income during retirement. Tens of millions not yet collecting benefits are hoping it will do the same for them. Maximizing the benefits available to them is a growing concern among clients.
It can be difficult deciding when to begin collecting Social Security benefits. The question is one of the first on the mind of anyone approaching age 62. Because the decision is based upon future variables (life expectancy/longevity, investment performance, inflation factors, etc.), there is no way to determine with absolute certainty that a decision made today is the correct or most beneficial decision; only time will tell. With that in mind, one must analyze the retiree’s overall financial situation, evaluate the alternatives and options presently available, and make a decision that is reasonably expected to be the best decision today. This article provides some general guidance on the decision.
There are several types of benefits available through the Social Security system, including disability, dependent, and survivor benefits, but retirement is the most common. Retirement benefits will be the focus of this article.
In general, an individual age 62 or older is eligible to collect Social Security retirement benefits if they are “fully insured,” meaning they earned the required number of Social Security credits, typically 40. A credit is earned for every $1,200 of earnings each year, up to a maximum of four credits per year.
A spouse is eligible to receive benefits beginning at age 62. A spousal benefit is payable to a spouse or former spouse of an eligible worker. If presently married, the worker and spouse must have been married for at least one year. An unmarried divorced former spouse is eligible if the marriage lasted at least 10 years and the eligible worker is at least 62.
The retirement earnings limit affects Social Security beneficiaries who begin benefits before attaining full retirement age. (The Senior Citizens’ Freedom to Work Act of 2000 eliminated the retirement earnings test for people who have attained full retirement age.) For 2015, a Social Security recipient can earn up to $15,720 without surpassing the retirement earnings limit. Any amount earned in excess of this limit will result in $1 of Social Security benefits being withheld for every $2 of earnings above the limit. For a Social Security recipient who reaches full retirement age during 2015, up to $41,880 can be earned in the portion of the year before the month in which you attain full retirement age. If this earnings limit is exceeded, $1 in benefits will be withheld for every $3 in excess of this limit. Once the month of full retirement age is reached, the earnings limit disappears. For Social Security purposes, an age is reached on the day before your birthday.
There are a few other less common situations that need to be mentioned before delving into the details of retirement benefits. The Government Pension Offset (GPO) and Windfall Elimination Provision (WEP) are two methods of computing Social Security benefits that differ from the standard calculation. The GPO is used when one has worked for a federal, state, or local government and was not covered by Social Security for the last 60 months of employment. The WEP affects individuals who receive certain government, nonprofit organization, or foreign pensions, and, if it is applicable, the primary insurance amount calculation is altered to reduce benefits.
Social Security retirement benefits are based upon an individual’s primary insurance amount. This is the amount that would be received if an individual began claiming benefits at full retirement age. Full retirement age starts at age 65 for an individual born prior to 1938, and increases in a nonlinear manner to age 67 for an individual born in 1962 or later. Although the actual calculation is somewhat detailed, the amount of Social Security benefits at full retirement age ranges from about 56 percent of compensation subject to Social Security tax at low levels of compensation to 28 percent at high levels of compensation. Please keep in mind that the compensation level driving this ratio is compensation subject to the Social Security tax ($118,500 in 2015). Compensation in excess of the Social Security tax maximum does not affect this ratio or the Social Security benefits. The calculation of the primary insurance amount is dependent on a worker’s average indexed monthly earnings, an indexed calculation of lifetime earnings. Social Security benefits claimed at any time before or after full retirement age are subject to an adjustment, either a reduction from the primary insurance amount for benefits beginning before full retirement age – referred to as permanently reduced benefits – or an increase above the primary insurance amount for benefits delayed until after full retirement age – referred to as delayed retirement credits.
Retirement benefits can be claimed as early as the first full month that someone is age 62. As mentioned, the Social Security Administration considers an age reached on the day before the birthday, therefore someone born on the 1st or 2nd day of a month is the new age for the entire month, whereas someone born on the 3rd day or later must wait until the following month to be eligible. The permanent reduction in benefits is dependent upon how many months prior to full retirement age one begins receiving benefits. Benefits are reduced by 5/9 of 1 percent for each of the first 36 months (6.67 percent per year) before full retirement age and by 5/12 of 1 percent for each month over 36 months (5 percent per year). For example, someone whose full retirement age is 66 and who begins collecting at the earliest point in time (age 62) will incur a permanent reduction of 25 percent, or will collect a benefit equal to 75 percent of the primary insurance amount.
Delaying benefits until after full retirement age also results in a permanent change, but this is a permanent increase in benefits. The delayed retirement credit increase is equal to 8 percent per year, prorated for each month, that benefits are delayed past full retirement age up to age 70. (The delayed retirement credit increase of 8 percent per year is for anyone born after 1942.) Someone whose full retirement age is 66 and waits the entire four years before collecting Social Security will receive a 32 percent increase in benefits over the primary insurance amount.
For all of the benefit-claiming strategies discussed in this section, the assumption is that full retirement age for all individuals is age 66. References to starting benefits at age 62 or delaying to age 66 or age 70 are for illustration only. Benefits can begin any month from age 62 to age 70.
Single Individuals (Never Married)
– Immediately upon eligibility at age 62 or sometime later, the decision to collect Social Security is based on two objective factors, as well as personal preference. The two objective factors are current earned income and cash flow availability. As mentioned earlier, receiving benefits before full retirement age will result in a permanent reduction in the benefit, but there is also the retirement earnings limit to be concerned with. If an individual has earned income in excess of that limit, it makes little or no sense to begin receiving benefits only to forfeit half of them and continue to suffer from the permanent benefit reduction. Therefore, in the scenario where a recipient is pre full-retirement age, still working, and earning in excess of the retirement earnings limit, the decision is easy: delay drawing benefits.
The caveat to this simple scenario is the amount of earnings in excess of the retirement earnings limit. If we change the scenario slightly, whereby the individual is earning an amount slightly in excess of the retirement earnings limit, say $1,000 in excess, the decision is more complicated, and the next factor, cash flow availability, kicks in. The bottom line is that you need money for food, clothing, shelter, and other basic necessities. If there are no other resources, financial or societal, and the Social Security benefits (even at a reduced level) will be the difference between maintaining or losing a home or affording some other needs, beginning benefits makes sense. This is certainly an extreme example, and obviously the greater the amount in excess of the limit the less likely that drawing benefits makes any sense.
Now consider the scenario where the worker is retired with no earned income (so the retirement earnings limit is not a factor) and has sufficient other resources (retirement and/or nonretirement cash and investments, pension income, etc.) to provide for living expense needs. The decision would now rest on life expectancy. It was previously noted that beginning benefits at age 62 will result in a permanent benefit reduction of 25 percent from the primary insurance amount. Without factoring in investment returns or cost of living adjustments, it will take 12 years (to age 78) to recover the benefits not taken from age 62 to age 66. (Example: A primary insurance amount of $1,000, which would result in a permanently reduced benefit of $750. The four years from age 62 to 66 would result in total benefits paid of $36,000. The additional $250 per month of the primary insurance amount starting at full retirement age will recoup this difference over 144 months.) Therefore an expected life expectancy beyond age 78 would result in a decision to delay benefits until age 66.
Delaying benefits beyond full retirement age results in an increased benefit resulting from delayed retirement credits, to as much as 32 percent if benefits do not start until age 70. This decision would still focus on the life expectancy variable. Again, without factoring in investment returns or cost of living adjustments, it will take 12.67 years (almost to age 83) to recover the benefits not taken from age 66 to age 70. (Example: A primary insurance amount of $1,000 for the four years from age 66 to 70 would result in total benefits paid of $48,000. The additional $320 per month resulting from the delayed retirement benefits will recoup this difference over approximately 152 months.) Therefore, an anticipated life expectancy beyond age 83 would result in a decision to delay benefits until age 70.
Two planning options offered by the Social Security Administration also may alter the timing of a decision, if not the decision itself. The first is the withdrawal of an application for Social Security retirement benefits, more commonly known as “The Do-Over.” If an application for benefits has been filed and benefits are being received, the application can be withdrawn and the account reinstated as if the application had never been filed if two criteria are met. The first is that the withdrawal must occur less than 12 months from when the entitlement to retirement benefits became effective. The second criteria is that all benefits received, including spousal and dependent benefits resulting from the application as well as any money voluntarily withheld from the Social Security benefit payment, must be repaid in full within that 12-month window. Know that anyone receiving benefits based on this application (spouse/dependent) must also consent in writing to its withdrawal and that this withdrawal provision is limited to once in a lifetime. The second planning option is Suspending Retirement Benefit Payments, more commonly known as “File and Suspend.” This planning option is only available once full retirement age has been reached. By suspending benefits, the account will continue to earn delayed retirement credits to age 70.
For an unmarried individual, the Do-Over would likely only be used before attaining full retirement age. It gives an individual the ability to get an interest-free loan from the Social Security Administration for a period of up to one year and also “reset” the benefit to an amount that is at least 5 percent higher (based on a one-year revision from age 62 to 63). There are, of course, tax and cash flow implications that need to be considered, but in those few situations where someone thought they needed the additional cash flow but ultimately didn’t, the benefits can be repaid and a new timetable established for drawing benefits.
The File and Suspend election is much more useful. Assuming the individual has reached full retirement age, the application for benefits can be filed and immediately suspended. While this technique is more commonly used with married couples (addressed below), it also has usefulness for an unmarried individual. Let’s say this unmarried individual is unsure of cash flow needs or has uncertain health issues. By filing and suspending, the eligibility for benefits is established and, for illustrative purposes, let’s say that the benefit is being put in an envelope with their name on it at the Social Security Administration. There are now two options: decide when benefits should start without tapping into this envelope and receive a higher monthly benefit amount based on the delayed retirement credits, or reinstate the benefits retroactively to as far back as the date of the election to suspend and receive a lump-sum payout and ongoing benefits as if the election to suspend had never been filed. Even an otherwise healthy individual at full retirement age may choose to File and Suspend in the event of something happening that would shorten life expectancy or create a financial hardship.
Single Individuals (Previously Married)
– There are some additional planning opportunities for divorced individuals who are not currently married. Provided the marriage lasted 10 years or longer and the ex-spouse is at least age 62, the Social Security Administration essentially disregards the divorce and allows the individual to file for benefits and receive the higher of the benefit to which they are entitled based on their own earnings history or the benefit to which they would be entitled based on the earning history of the ex-spouse. There is also no requirement that the ex-spouse have filed for benefits in order to claim the “spousal” benefit. The divorced individual can also wait until full retirement age and file a restricted application for spousal benefits only, thereby collecting only the spousal portion of the benefit while allowing their own benefit to continue accruing delayed retirement credits. The restricted application is just what it sounds like: an application to receive only a spousal benefit. (More on this below.)
– Married individuals, assuming the marriage has lasted at least one year, have the same strategies available to them as do single individuals, plus some additional strategies that could enhance their combined benefits. There are innumerable variables that come into play for couples, including whether each qualifies for their own benefits, the primary insurance amount for each, their ages and the age difference between them, as well as life expectancy and cash flow matters. When discussing planning options for a single individual, I touched on the File and Suspend and “restricted application” planning strategies. Where they really come into the equation is with married couples. Here are a few simplified examples in which both spouses are eligible for benefits based upon their own work history, there are no health or longevity concerns, and cash flow needs are not an important factor in the decision.
Let’s say the spouses are four years apart in age and full retirement age for both is age 66. The older spouse (O) has a primary insurance amount of $2,500 per month, and the younger spouse (Y) has a primary insurance amount of $2,000 per month. Since cash flow is not needed, O will wait until at least full retirement age to file for benefits. O reaches full retirement age at the same time that Y reaches age 62. They have several options. Option 1 is to do nothing: neither would file for benefits, so O would continue to earn delayed retirement credits and Y would not have a permanent reduction that lessens benefits. Option 2 is to have both file for benefits: O would receive the primary insurance amount of $2,500 and Y would receive a reduced benefit of $1,500 per month, which is a 25 percent permanent reduction in benefits. Option 3 is to have Y file for benefits and have O file a restricted application for spousal benefits only. Y would again receive the reduced benefit of $1,500 per month, but now O would receive a spousal benefit of $1,000 per month while O’s individual benefit continues to earn delayed retirement credits.
If they decide on Option 1 and do nothing at present, they will continue to have all three options available to them each month for four years, until O turns age 70 and Y reaches full retirement age, at which time O will now collect a benefit of $3,300 and there is an additional claiming option. This fourth option is for Y to file a restricted application for spousal benefits, thereby collecting a spousal benefit of $1,250 per month while continuing to earn delayed retirement credits for his or her own account. Y would then switch to his or her own benefit at age 70, which would now be $2,640 per month as a result of the delayed retirement credits. In addition, the Do-Over is available to either spouse who has filed for benefits on their own account.
For a second example, let’s say the spouses are the same age and have the same primary insurance amount. Aside from the early filing option beginning at age 62, there is not much to consider until both reach full retirement age. At that time, they have the following options. Option 1 would be for each to file for benefits on their respective accounts. Option 2 would have one file for benefits on his or her own account and the other file a restricted application for spousal benefits only. This allows one of their accounts to earn delayed retirement credits. Option 3 would have one File and Suspend, and the other file a restricted application. By doing this, both will continue to accrue delayed retirement credits and maximize their combined age 70 benefit. There is not a fourth option here. It is not permissible for both spouses to File and Suspend against their own accounts and also file restricted applications against the spouse’s account. The same individual cannot utilize File and Suspend and the restricted application for spousal benefits at the same time.
The Social Security benefit decision is not as simple as many clients believe. It is one that requires a significant amount of thought and analysis. From an adviser’s perspective, it is important to understand the client’s cash flow needs, income and tax situation, as well as the client’s marriage history, health situation, longevity expectations, and personal preferences.
Alan M. Schapire, CPA, PFS, CFP, is a founding principal of Convergent Financial Strategies LLC in Wayne. He can be reached at firstname.lastname@example.org.