At age 62, anyone with forty quarters of full-time work paying Social Security taxes may draw a permanently reduced benefit: reduced a half percent for every month prior to reaching full retirement age, usually referred to as the normal retirement age (NRA).
One can delay benefits beyond the NRA, but no later than age 70. Delay causes benefits to inflate by about 2/3% monthly (8% annually). About half of Americans start Social Security at the earliest point, most of these because of budget need. One argument for taking it early is that it stops upon death, though a married person will receive the larger of the two benefits (a beneficiary may draw from only one person’s account at a time).
There are two main tax considerations for Social Security payments:
- Ordinary income tax treatment of Social Security payments if you simultaneously have other income (earned or not); this occurs regardless of whether the penalty is imposed.
- A penalty (payment reduction) is imposed for those beginning payments prior to the NRA if they also have earned income. Both of these “take-backs” will apply if both conditions exist. Let’s examine those conditions.
Income Tax Considerations
For income tax on Social Security benefits, regardless of your age, total half of your Social Security payment with all of your other income sources regardless of source or tax characteristic (rare exclusions noted below). Call this total “combined income”; this does not refer to being married, per se.
But if you are married and filing jointly, add in both spouse’s incomes and half of each spouse’s Social Security to get combined income. Anything that would reduce your taxable income on your tax return also reduces the combined amount for this purpose. There are rare exclusions in this totaling of income, such as IRA contributions, adoption incentive income, certain foreign income, and US Savings Bond interest. The various thresholds are as follows:
- Married filing jointly: For combined incomes between $32,000 and $44,000, up to half of Social Security benefits are taxable. Above $44,000, up to 85% of benefits are taxable.
- Filing single or married/separate: For combined incomes between $25,000 and $34,000, up to half is taxable. If income is above $34,000, up to 85% of benefits may be taxed.
The best strategy, for those whose budget can stand this, is to have the SSA suspend payments, or rescind your application (twelve-month limit). With suspension, your Social Security payment will inflate 2/3% per month until you resume.
Rescission: Up to one year after application (not after receiving benefits) you may rescind your application, but must pay back benefits paid to that point (this causes the 2/3%-per-month growth to be retroactive to the application point). One drawback is that a current spouse’s spousal benefits from your account will also have payments suspended (and must be refunded in the twelve-month do-over option).
Penalty Considerations
If you draw Social Security but continue to earn an income, there are two tiers of reductions in that benefit. Again, these tiers only apply to earners who take Social Security while they are younger than their NRA. Note that especially if you have investment (unearned) income, you may be in a high enough tax bracket at the state and federal level to render earning a modest income not worth the effort.
The 2018 threshold on earnings beyond which Social Security is reduced by 50% is $17,040. But if you work, you also incur payroll taxes, and your employer pays you less salary because that employer must remit a similar amount of payroll tax. Employers consider the total cost of employing anyone, so when they negotiate pay, employees always get paid less by the amount the employer must pay behind the scenes. But I digress—back to the penalty. If your earnings after starting Social Security are just a bit above the threshold, try to negotiate other benefits that are not deemed income. Considering other taxes, your Social Security benefit could be taxed at an effective rate around 80% (especially if you are single and without much in deductions). One strategy might be to start some valid business whose expenses in early years reduce taxable income. It is scant help that your base benefit grows while you incur the penalty.
Once you reach your NRA, this limit becomes higher and the penalty reduces somewhat. A person at or beyond NRA can earn up to $44,880 in that year up to the month before the month in which they reach NRA without any reduction in Social Security payments. If they earn over the threshold, SS benefits will be reduced $1 for every $3 of overage.
Back pay, settlements for lost pay, and nonqualified deferred compensation are all considered earned income that can reduce Social Security payments, although these will increase your basic benefit because payroll tax is paid on these earnings. Also, tax-exempt interest income will be counted as earnings for purposes of determining this penalty. Here’s the test for penalty avoidance planning purposes: www.ssa.gov/OACT/COLA/rtea.html.
Normal retirement age, subject to change and variable, is based on your birth date. It will likely change soon, as might the entire Social Security system, perhaps even changing to a cash balance, rather than pension system or a hybrid. So please become familiar with SSA.gov and consider joining the lobbying group that best champions your concerns. NRA is published at https://www.ssa.gov/OACT/ProgData/nra.html.
A Thought for High Earners
In 2018, the limit on payroll taxation toward Social Security benefits is $128,400. This is also the limit of income that increases the Social Security benefit itself. So while these strategies must be modeled, a person who can defer income has two possible strategies: Defer the income (bonus, whatever) into a spread of years to maximize the eventual Social Security benefit. Alternatively, accelerate the income in order to avoid Social Security payroll taxes on the part that exceeds this limit.
A person who has self-employment income pays the self-employment tax as well; this must be included in any modeling in order to solve for an optimal timing strategy for income recognition versus deferring.
Strategies for Application Timing
As previously noted, there are thousands of possibilities. But a very common choice is the split age strategy (aka 62/70): The likely candidate for 62/70 is a couple with widely differing benefit amounts and the larger benefit deriving from the spouse with the likely briefest lifespan of the two.
The spouse with the lowest benefit and longest likely lifespan takes a 6%-per-year reduced Social Security benefit at age 62. The reduction is a small amount and the inflation factor of 8% strongly builds the deferred larger benefit of the two (up to age 70). This larger benefit of the two eventually—likely—becomes the widow or widower’s payment. This is so regardless of who dies first; there is no loss of the larger benefit merely because it had not been started at the time of death.
Note, however, that a widow who has not remarried at the time of application for Social Security Survivor benefits must be at least 60 (50 if disabled) and will incur an actuarial reduction in benefits if applying prior to NRA. A divorced survivor can also claim a deceased spouse’s larger benefit only if four conditions simultaneously exist: (1) the marriage lasted at least ten years; (2) the divorced survivor is at least 62 years of age (52 if the divorced survivor is disabled when applying); (3) the survivor has been divorced at least two years; and (4) this applicant is not eligible to take a higher benefit from his or her own or another person’s account. Such take-overs are not “spousal benefits,” which are benefits of up to half of one spouse’s primary benefit that can be applied for by spouses who lack qualification or who wish to allow their own account to grow before accessing their own account.
Strategy of Taking a Spousal Benefit Off a Larger, Deferring Account, Aka ‘file and Suspend.’
Typically, this is used when one spouse continues to work. The benefit for the working spouse is applied for but immediately suspended; this allows the other spouse to take a “spousal benefit” up to half of the non-drawing spouse’s own benefit. The non-drawing spouse allows continued growth in his or her benefit (at 8% annually) but that does not increase the spousal benefit by this growth (only a cost of living inflator, if approved by Congress, inflates the benefit being taken).
A spouse who would draw the highest benefit waits to draw Social Security. This is attractive only if the non-drawing spouse is in good enough health to watch it defer (perhaps as long as the maximum limit, age 70). This is because that benefit inflates 8% yearly until death or drawing the benefit. A spousal benefit from that deferred account (or the lower of the two accounts) could be taken earlier than the deferring account. Using this spousal benefit or, alternatively, the spouse activating his or her own smaller normal payment, can help the couple’s budget until the larger deferred account is accessed. But taking a spousal benefit (rather than one’s own smaller account) and then taking over the larger account that had been deferred has a drawback requiring payback of the spousal benefit in order to access a deceased spouse’s larger deferring account.
Here is that payback strategy (aka do-over) for those drawing a spousal benefit (i.e., they have not activated payments from their own account): The person drawing a spousal benefit can pay back all spousal benefits received (have a good cash reserve!). This action qualifies him or her for full takeover of a deceased spouse’s larger benefit (it usually had been growing nicely because it was deferred). But the spousal benefits must be repaid to gain this right. In essence, this is an interest-free loan for a year while the basic benefit grows by 8%.
This excerpt is taken from “The Secrets of Successful Financial Planning: Inside Tips From an Expert,” by Dan Gallagher. To read other articles of this book, click here. To buy this book, click here.
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