Considering the increased financial risks retirees now shoulder, a strong argument can be made that Social Security should pay a greater role in their financial planning. However, many retirees today do not understand how their Social Security benefits really work.
While some seniors are simply uninformed, others are dangerously misled by the “conventional wisdom” surrounding Social Security. Unfortunately, these misconceptions prevent individuals from taking steps well within their control to maximize this important benefit.
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Here are the four costly mistakes retirees often make about their Social Security benefits:
Mistake No. 1: Underestimating the value of Social Security For years, financial service providers have warned us that Social Security will never provide enough income during retirement. While this may be true for many, Social Security is nonetheless an important component of total retirement income. A 66-year-old worker who has $80,000 of annual wages just before claiming Social Security benefits and a non-working spouse can expect to initially receive about $34,000 in annual Social Security income.
As the income guarantees provided by private employer pension plans disappear, Social Security guarantees become even more critical to participants, who may spend 25, 30 and even 40 years in retirement. Social Security provides valuable protection against this “longevity risk.”
While you are working, the value of Social Security continues to grow along with your wages. Once you start receiving Social Security during retirement, these benefits are adjusted for inflation each year and help preserve the purchasing power of your retirement income.
Other than calling for changes to the Cost-of-Living-Adjustment formula, no serious reform proposal has been offered that would reduce Social Security benefits for those at or near retirement.
Mistake No. 2: Rushing to collect benefits Retirees often apply for Social Security benefits early then find themselves regretting the reduced checks for the rest of their lives.
There’s a financial penalty for claiming Social Security benefits between age 62 and your full retirement age (66 for people born between 1943 and 1954, between 66 and 67 for those born between 1955 and 1959 and 67 for those born in 1960 and later). For example, your benefit at age 62 might be 75 percent of what you’d get if you waited until your full retirement age.
And your benefits increase 8 percent each year you delay claiming them between your full retirement age and age 70 due to what’s known as the "delayed retirement credit."
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When you factor in the penalties, credits and Cost of Living Adjustments, you could potentially double your initial Social Security payments by waiting until age 70 to start collecting benefits.
The discussion regarding when to take Social Security benefits tends to focus on the “break-even” age — the point at which you could receive more income from starting Social Security benefits earlier versus starting them later. Some online Social Security calculators also factor in income you could theoretically earn on your benefits once you start receiving them. However, these assumptions ignore key considerations:
- The value of Social Security Cost of Living Adjustments.
- The tax preferences awarded to Social Security income, compared to taxes on IRA withdrawals.
- The ability to integrate each spouse’s Social Security benefits to provide optimal income.
- The Social Security survivor’s benefit, passed on to a spouse at death.
- The ability of Social Security to provide longevity risk protection in the form of retirement income for life.
Mistake No. 3: Not understanding how couples can integrate benefits Perhaps the most confusing aspect of claiming Social Security is understanding the different types of retirement benefits that married spouses might be eligible to receive and how those benefits might interact.
At one time or another, a married spouse may receive a spousal benefit, a worker benefit or a survivor benefit. To create the right strategy for a given situation, it’s important to understand the different types of benefits and when they might become available:
* The worker benefit If you have worked and contributed to Social Security for 40 quarters (roughly 10 years), you are likely eligible for a worker benefit, known as the primary insurance amount, or PIA, at your full retirement age. The earliest you can file for your worker benefit is the first month in which you are 62 for the full month.
* The spousal benefit Assuming your spouse has filed for benefits, Social Security spousal benefits can begin the first full month you turn 62. Spousal benefits, however, do not earn delayed retirement credits if you delay claiming Social Security past your full retirement age.
The spousal benefit is often thought of as being the greater of what a spouse earns on his or her own work record, or one-half of the other spouse’s benefit. Unfortunately, it gets more complicated than that.
To understand how the spousal benefit works, let’s start with a married couple, Mary and Ken. Assume they both turn 62 and become eligible for benefits on the same day and that their full retirement age is 66.
If Ken, the higher earner, filed for his worker benefit, a spousal benefit may be payable to Mary. The simplest way to figure out if Mary can receive it before she turns 66 is to determine what her worker benefit would be at that age. If it's less than half of Ken’s at 66, Mary would be eligible for a spousal benefit that amounts to the difference between her PIA and half of Ken’s total.
So, although you might think Mary is getting a larger spousal benefit based on Ken’s work record, she is actually receiving two benefits: her worker benefit, plus the spousal benefit.
To see how the numbers work, assume that at age 66 Ken is eligible for a worker benefit of $2,000 a month and Mary is eligible for her worker benefit of $600 a month. Half of Ken’s PIA ($1,000) minus Mary’s PIA ($600) equals $400 — the spousal benefit that Mary would qualify for.
So if Ken and Mary file for Social Security at 66, Ken would receive $2,000 and Mary would receive $1,000 (her $600 worker benefit plus her $400 spousal benefit).
If Ken decided to take his benefits at 62, at a reduced amount of $1,500 per month, Mary could still receive her full $1,000, as long as she waited until her full retirement age to apply for Social Security. But if Ken doesn’t file early, Mary can’t file for her spousal benefit early. She’d be filing for her worker benefit, with the reduced benefits for claiming Social Security early.
* The survivor benefit Delaying Social Security not only increases your own benefit, but it can also increase the benefit to your surviving spouse. Upon the death of an individual, the spouse will get the greater of his or her own Social Security benefit at the time or the deceased spouse’s benefit.
In essence, the value of delaying Social Security continues, as the higher benefit (which has grown even higher due to Cost of Living Adjustments) is passed on at death to a spouse. This is an important way to help provide income protection to a surviving spouse.
It’s also worthwhile noting that the smaller benefit drops off at this time. So no matter which spouse dies first, the smaller benefit disappears. This lessens the value of delaying Social Security for the spouse with the smaller Social Security benefit.
The Social Security survivor benefit could help offset potential health care costs and everyday expenses. It also helps protect surviving spouses from inflation, since they’ll receive annual Social Security Cost of Living Adjustments. Better still, the Social Security survivor benefit is taxed at a lower rate than ordinary income. All in all, it’s difficult to reproduce this security for a spouse through other financial products.
Married couples may find that, because of the survivor benefit rules, it’s beneficial for the spouse eligible for the lower Social Security payments to start collecting his or her own worker benefit early, while delaying the other spouse’s benefits.
Mistake No. 4: Getting blindsided by "The Tax Torpedo" All the money you have put into 401(k)s over the years, all your employers’ 401(k) matches and all your 401(k) earnings will eventually be withdrawn — and taxed. Those withdrawals (perhaps coming out of a rollover IRA you opened to hold your 401(k) money after leaving your jobs) will then increase your income and therefore trigger higher taxation of your Social Security benefits.
So instead of enjoying a lower tax rate in retirement, as you might expect, the marginal tax rate on your 401(k) and IRA withdrawals may be much higher than the tax rate you were paying on your earnings when you were working. You may then be facing what some call “The Tax Torpedo.”
Depending on your income, up to 85 percent of your Social Security benefits could be taxed. That could have the effect of pushing your total marginal tax rate (state and federal taxes) over 50 percent.
That’s why the conventional wisdom to delay withdrawals as long as possible from tax-deferred accounts, like IRAs, may not be wise for many retirees. Doing so may just create a greater deferred tax liability due to the high marginal rates that you’ll ultimately owe, and that's probably something you'd rather avoid.