May 29, 2018
Making Optimal Decisions with Social Security Benefits
May 29, 2018
By Michael Zaidlin, J.D.
Social Security benefits often constitute a majority of retirement income, with the median married couple or individual recipient relying on Social Security for 67% of retirement income. Many married couples will receive over one million dollars in lifetime benefits. In many cases, the amount of benefits a married couple will receive will exceed the amount of income that can reasonably be provided by even a $1,500,000 IRA account.
Despite the importance of making a carefully considered decision about when to file, many individuals miss out on tens of thousands of dollars in lifetime benefits by filing too early or because they lack awareness of particular filing strategies. Married (and many divorced) couples, for whom Social Security retirement benefits serve as a “joint-and-survivor” annuity, often forego several hundred thousand dollars in combined lifetime benefits.
There are a number of reasons for this. Individuals invariably underestimate their own life expectancy, place too little value on Social Security’s primary role as longevity insurance, focus far too much on the “break-even” aspects of a filing decision, and fail to take into account that a lower earning, younger spouse is very likely to “step-up” to the higher earning spouse’s benefit, often for many years.
For many attorneys, a general understanding of Social Security is useful. For example, the ability of a divorced spouse to collect a survivor or spousal benefit – or both - based on the work record of an ex-spouse requires that the marriage have lasted a minimum of ten years, among other factors. Remarriage may impact the client’s ability to qualify for certain benefits in the future. For estate planners, retirement or survivor benefits will often impact how financially secure a surviving spouse will be, as well as impact the size of the client’s remaining estate.
The goal of this article is to provide general information on Social Security’s rules and benefits, describe a number of filing strategies, and highlight other information relevant to the filing decision. The reader should be aware that there are many exceptions to the general rules described below, particularly when disability benefits are involved.
The optimal filing decision often appears deceptively simple, yet for many filers there will often be hundreds of possible filing options involving timing and benefit combinations. The complexity, and the financial stakes, should nearly always warrant the use of suitable software or professional assistance, except in the most basic of situations.
Full Retirement Age and the Retirement Benefit.
Full retirement age (FRA) is the age at which one is entitled to a full retirement benefit, also known as the “Primary Insurance Amount.” FRA is based on one’s date of birth – it is 66 for those born from 1943-1954, increasing by two months for each year until 1960, when FRA is 67 for those born in that year and after. The size of the retirement benefit is based on the highest 35 years of one’s “covered” Social Security earnings.
For each year in which the retirement benefit is delayed past FRA, the benefit will grow via “delayed retirement credits” by approximately 8% annually to age 70. Conversely, taking the benefit before full retirement age will reduce the benefit size by just under 7% per year to age 62. For example, one entitled to an annual retirement benefit of $30,000 at age 66 would collect $22,500 if filing at age 62, or $40,000 if filing at age 70.
The retirement benefit can grow for as long as one works, which also has the secondary benefit of allowing dependent and survivor benefits to grow as well. For those who already have a long, solid earnings history, further work is likely to have little impact on the size of the retirement benefit, but growth can be dramatic when one has relatively few years of covered earnings or has earnings which have significantly increased over time.
Certain Social Security rules change depending on whether or not one has reached full retirement age, which affects filing strategy. These include:
- Filing a “restricted application for spousal benefits” upon reaching FRA is still available to those born before 1954.
- One cannot suspend benefits before FRA.
- The earnings test no longer applies at FRA.
- Spousal and survivor benefits do not increase in size after the claimant has reached FRA.
Retirement Benefits and the Impact of Delaying Beyond FRA.
Delaying benefits past FRA can have a major impact on total lifetime benefits, particularly when an older spouse is the higher earner, and may result is an additional $200k-$250k in lifetime benefits for a married couple. Social Security benefits constitute a unique form of “longevity insurance” because they are tax-favored, inflation-protected, and government-backed. No other annuity offers all three features.
Because the median life expectancy of a 65-year-old is now 86 for a woman and 84 for a man, and because life expectancies are anticipated to increase at an ever-faster pace, Social Security’s role as longevity insurance is critical. In addition, those who rank in the top 25% of education and/or income levels have life expectancies that are about three years longer than the population as a whole. Of course, it may not always be beneficial to delay filing when heath/life-expectancy issues are evident or anticipated.
The family of a worker who is taking retirement benefits, and who has a child under 18 still living at home (or older if disabled before age 22) is eligible for child, as well as child-in-care spousal benefits, regardless of the age of the spouse. This is just one scenario which may make early filing more beneficial than delaying, depending on life expectancies and other factors.
Delaying Benefits and the Impact on an Investment Portfolio.
Delaying Social Security benefits often results in smaller taxable retirement account withdrawals due to the increased size of the benefit, a combination which should also result in a reduction in taxes as higher tax-favored Social Security benefits are “exchanged” for smaller tax-disfavored IRA withdrawals. Combined with the built-in inflation protection of benefits, delaying should result in a higher level of after-tax income, a retirement income stream with lower overall risk, and thus an investment portfolio requiring less exposure to risk.
Because Social Security benefits constitute tax-favored and inflation-adjusted longevity insurance, this further reduces the risk of depleting investment accounts during retirement. Those who are risk-averse are particularly well served by delaying, as having a higher percentage of retirement assets in the form of an annuity such as Social Security results in an overall lower-risk retirement portfolio.
The Surviving Spouse and the Survivor Benefit.
Due to the survivor step-up, the filing decision for both spouses must be jointly coordinated, as the higher retirement benefit will constitute a “joint and survivor” annuity that will end only at the death of the lower-earning spouse. The step-up to the deceased’s retirement benefit occurs at the death of the first spouse, but only if the deceased was receiving a larger retirement benefit than the surviving spouse.
To be eligible for a survivor benefit based on the work record of one’s spouse, one must have been married a minimum of nine months. For divorced spouses, (where filing coordination can also be highly desirable for the lower-earning spouse) the marriage must have lasted a minimum of ten years. In addition, if currently married and seeking a survivor benefit based on the work record of a deceased ex-spouse, the current marriage cannot have begun prior to age 60.
For the older, higher-earning spouse, a key guideline regarding when to file for retirement benefits is whether at least one spouse can be expected to live past the general “break-even” age, which, depending on current interest rates and other factors, has historically been in the 81-84 age range. If either spouse can reasonably be expected to live to this age range, it often makes sense to have the higher earning, older-spouse delay benefits.
If H is the higher earner and significantly older than W, it is extremely likely that W will step-up to a survivor benefit. In that case, it may be optimal for W to file early for a benefit, since that benefit is likely to be replaced by the larger survivor benefit before W reaches her “break-even” age. Many younger, lower earning spouses outlive their spouses by many years, even decades, which can mean the difference between collecting $25k in annual survivor benefits, or $40k, for many years.
Today’s Filing Decision and the Impact on Tomorrow’s Survivor Benefit.
The size of a survivor benefit is dependent on both whether the deceased filed for retirement benefits before or after reaching FRA, as well as on when the surviving spouse files for the survivor benefit. There are four possible outcomes:
- Both spouses wait until FRA or after to file. Here, the survivor benefit amount will be what the deceased was collecting at the time of death, or which would have been collecting had he or she filed at that time.
- The deceased files at or after FRA, and the surviving spouse files before FRA. This may drop the survivor benefit to 71.5% of the amount the deceased was receiving.
- The deceased files before FRA, and the surviving spouse files at FRA. This may drop the survivor benefit to 82.5% of the amount the deceased was receiving.
- Both spouses file before FRA. This may reduce the survivor benefit to 71.5% of the deceased’s full retirement benefit.
The Impact of “Deemed Filing” on Retirement and Spousal Benefits.
With few exceptions, whenever one files for a retirement or a spousal benefit, one will be presumed (“deemed”) to be filing for all of the benefits that one is entitled to at the time of filing, and will simply be awarded the highest of those benefits. Except in certain circumstances, deeming eliminates the option of taking one benefit now, while allowing another benefit to continue to grow, a process often referred to as “being paid to wait.”
In certain cases, one can take a survivor benefit, or a spousal benefit via a restricted application, while letting a different benefit continue to grow, then switch over to that benefit – in effect, being “paid” to wait. Under the 2015 Bipartisan Budget Act, only those born before 1954 are now eligible to file a “restricted application” for a spousal benefit without being deemed to be filing for retirement benefits.
Switching Between Survivor and Retirement Benefits.
Because deeming does not apply to survivor benefits, one may take a survivor benefit while allowing a retirement benefit to grow, then switch to the retirement benefit at a later date. Or, the retirement can first be taken, while allowing the survivor benefit to grow. A survivor benefit may be claimed as early age 60 (age 50 if disabled and the disability started within seven years of the deceased’s death.)
As noted earlier, the survivor benefit does not grow after one has reached full retirement age, while the retirement benefit continues to grow in size until age 70. As a result, certain filing strategies may come into play between ages 60 and 70. For example, if one’s retirement benefit at 70 will be larger than his or her survivor benefit will be at age 70, it may be optimal to file as early as possible for the survivor benefit, then switch to the higher retirement benefit at age 70. Or, if one’s retirement benefit at 70 will be smaller than the survivor benefit will be at full retirement age, it, may be optimal to take the retirement benefit early, then switch to the survivor benefit upon reaching full retirement age.
Spousal Benefits for Married Couples.
The spousal benefit, if taken at full retirement age by spouse A, is equal to one-half of spouse B’s full retirement benefit. To file for a spousal benefit based on a current spouse’s work record, the couple must be married for a minimum if one year. Also, spouse A can only claim the spousal benefit when spouse B has first filed for his or her own retirement/disability benefit. The spousal benefit does not increase after one reaches FRA. Filing for a spousal benefit before FRA reduces the size of the benefit to as low as 35% if taken at age 62.
In addition to a spousal benefit, a “child-in-care spousal benefit” can be collected by that spouse at any age, with no reduction, if there are children under age 16 in care. This benefit is also 50% of the size of the full retirement benefit. However, the “family maximum benefit rule” will reduce the total benefits a family can receive to a maximum of 150%-180% of the size of the retirement benefit that the dependent benefits are based on.
Spousal Benefits for Divorced Spouses.
To be eligible to claim a spousal benefit based on ex-spouse A’s work record, the marriage must have lasted a minimum of ten years, and Spouse B cannot be currently married. (Eligibility for a spousal benefit based on an ex-spouse’s work record can, however, be regained upon divorce.)
Unlike married couples, each divorced spouse can file for spousal benefits. Also, if divorced for more than two years and at least 62, neither ex-spouse is required to wait until the other ex-spouse has filed for retirement benefits, as is the case with married couples. Finally, ex-spouse A’s current marital status never has a bearing on ex-spouse B’s ability to collect a spousal benefit.
Suspending Retirement Benefits at Full Retirement Age or Later.
Suspending a retirement benefit, which can only be done at or after reaching full retirement age, allows one to “correct” a too-early filing decision, and from the moment of suspension will allow the retirement benefit to grow by approximately 8% per year. Suspending a retirement benefit, (unless it was done before April 30, 2016 by those few who qualified to do so) will, however, now cause all dependent benefits to be immediately suspended as well.
Obtaining a “retroactive benefit” can be done when an individual realizes or otherwise decides he or she should have filed earlier for a particular benefit. Up to six months of missed benefits can be collected. A retroactive benefit cannot be filed for before reaching full retirement age.
Withdrawing Retirement Benefits.
Withdrawing one’s retirement benefit is the equivalent of never having applied for a retirement benefit at all. In effect, it resets the clock back to the day in which retirement benefits were filed for, so that the retirement benefit grows retroactively from that date. As with suspending a benefit, it serves to correct a “too-early” filing decision. Unlike suspending a benefit (which can only be done at or after FRA), withdrawing a benefit requires paying back any amounts receiving during that period, including dependent benefits and Medicare premiums.
There is a short window to withdraw retirement benefits – it must be done within 365 days of the date of the initial filing. If the one-year withdrawal deadline has passed, suspending benefits upon reaching full retirement age is the earliest moment at which benefits can be suspended, and allow the retirement benefit to grow. “Failing” the earnings test often has a similar impact as withdrawing or suspending retirement benefits.
The Earnings Test.
The earnings test applies when one is collecting benefits before full retirement age and has employment (or self-employment) earnings above a certain limit. Earnings do not include investment and other non-work-related income. In any year before the year in which the recipient reaches FRA, one dollar in benefits will be withheld in 2018 for every two dollars earned in excess of $17,040. In the year in which FRA is reached, one dollar in benefits will be withheld for every three dollars earned in excess of $45,360 in the months preceding the month in which FRA was reached. Dependent benefits may also be impacted by the earnings test.
Most of the time, the earnings test has an ultimately positive impact because it allows the withheld benefit to grow at 8% per year, similar to a withdrawn or a suspended benefit. However, certain benefits subject to the earnings test can be permanently lost, especially in cases where that benefit may only be collected for a specific number of years, such as a survivor or retirement benefit where one will be switching between the two benefits, or in the case of a child-in-care spousal benefit that may only last a few years.
Social Security Disability Insurance (SSDI) and Supplemental Security Income (SSI).
Specific claiming rules and strategies apply to the disabled and to their dependents. For example, a disabled surviving spouse or ex-spouse can take survivor benefits at 50, and in contrast to non-disabled workers who get their full retirement benefit at 66-67, disabled workers can obtain their full retirement benefit at age 62. An SSDI benefit amount is based on an age-based sliding scale - the older one is, the more work credits are needed to qualify. It is not “need-based” and therefore is not means-tested. Deeming does not apply to disabled workers. For example, collecting a spousal benefit before full retirement age will not permanently reduce the size of the worker’s retirement benefit.
Supplemental Security Income (SSI) is administered by the Social Security Administration, but is not funded by Social Security taxes. To a large degree, it is the program that has supplanted Welfare. It is intended for those who have not accumulated sufficient credits for covered earnings to qualify for SSDI. It is need-based, and therefore recipients are subject to is means-testing.
Federal Taxation of Social Security Benefits.
Social Security benefits are federally “tax-favored.” The Provisional Income (PI) formula determines the percentage of Social Security benefits that are taxed in a given year. Under the PI formula, either 0%, 50%, or 85% of one’s benefits will be subject to federal taxation. The particular bracket will depend on how much, and what type, of outside income one has. For example, IRA distributions are subject to the PI formula, and can increase the taxation of Social Security benefits, while qualified Roth distributions will not.
Because of the impact of the “tax torpedo”, in which outside income subject to the PI formula can cause one’s benefits to be subject to a higher tax bracket, combined with the fact that Social Security benefits are taxed at a lower rate than ordinary income (such as IRA distributions), taking higher benefits and reducing other taxable income can have dramatic impacts on one’s taxes. For example, a married couple filing jointly who receive $70k in benefits, and who take a $20k distribution from an IRA, would pay 75% less in federal tax than a couple who receive $45k in benefits and who take $45k from an IRA.
Finally, California does not tax Social Security benefits. Therefore, residents of California and other high-tax states often realize a further benefit from delaying and increasing the size of their Social Security benefits.
- The Social Security claiming decision is a key financial decision, often appearing deceptively simple but should be carefully evaluated with software, particularly when marriage is or has been involved.
- In an era of rapid advances in medical technology and life expectancy, Social Security, as a tax-favored, inflation-adjusted, government-backed annuity, represents the ultimate form of longevity insurance.
- Delaying Social Security benefits represents the most cost-efficient way to obtain more longevity insurance, compared to any commercial annuity.
- There are often sound reasons to take benefits early, particularly when disability benefits or a younger spouse are involved, when minor children are still living at home, when one can switch between types of benefits without being “deemed,” or when health or financial need are important considerations.
Michael Zaidlin, J.D, is the founder of Madrone Investment Advisory, LLC, a California registered investment advisor and financial planning firm based in San Rafael.