You’ve been paying tax into the Social Security system for many years now. Every time you receive your paycheck, you look at the stub and your eyes scan to the place where the deductions are spelled out. You grimace. It pains you to think of all of the money you have earned that never reached your bank account or your pockets.
Rest assured you are not alone. American workers across the country go through the same emotions every payday.
On January 1, 2013, a lame duck Congress at the last minute voted to approve legislation that would avoid what the media dubbed the “fiscal cliff,” a catchy term for the conundrum that the U.S. government would face at the end of 2012, when the terms of the Budget Control Act of 2011 were scheduled to go into effect.
With the precipice avoided, the maximum that employees and employers will now each pay in 2013 is $7,049.40, an increase of $2,425.20 for employees over the previous year and an increase of $223.20 for employers.
Other important measures approved include:
Social Security: The new Wage Base was increased to $113,700, an increase of $3,600 from the previous wage base of $110,100. As before, there is no limit to the wages subject to the Medicare tax; therefore all covered wages are still subject to the 1.45% tax.
Medicare: Taxable Medicare wages paid in excess of $200,000 are subject to an extra 0.9% Medicare tax that will only be withheld from employees’ wages. Employers will not pay the extra tax.
The Bush (President George W.) era payroll tax cut expired, resulting in 2% more in employee Social Security tax withholding. For the time being, the employer rate remains 6.2 percent. The Medicare rate, also matched by the employer, is unchanged at 1.45 percent and applies to all wages.
But since there is nothing we can do about any of it, except write our congressional representative, most Americans just wonder, “When do we stop giving and start taking?” This may be why many make the mistake of taking their Social Security checks as soon as possible. We have already made the case that starting Social Security at 62, while it may be emotionally satisfying, is not usually prudent. If you know how Social Security works, you’ll realize that there are two reasons why starting at the opening bell is, more often than not, a bad idea:
* Before your “full retirement age,” working and Social Security benefits don’t mix well. If you have even moderate amounts of earned income, your Social Security checks will be reduced or eliminated altogether.
* Even if you’re not working, starting at 62 or soon afterwards cuts the amount you’ll receive for the rest of your life. Uncle Sam provides generous incentives to wait as long as possible – until age 70 – to start collecting your benefits.
Labor Pains
Social Security has had an earnings penalty (now called by the more acceptable term “earnings test”) since the 1930s. The rules were changed in 2000. Today’s rules are more favorable to seniors who wish to keep working, but they’re a little complicated.
For the earnings test, seniors fall into one of three categories:
1. Those who have not yet reached the year of their full retirement age (FRA). At this writing, the FRA is 66. That applies to people born from 1943 through 1954. If you were born after 1954, FRA increasesgradually to 66 and two months, 66 and four months, etc. If you were born in 1960 or later, your FRA is 67.
2. Those who are in the calendar year of reaching their FRA, but not there yet. Suppose Art Young was born in June 1949. His FRA is 66, an age he’ll reach in June 2015. Thus, Art is in the first category in 2011, 2012, 2013 and 2014. From January through May of 2015, Art is in the second category.
3. Those who have reached their FRA. In June 2015, Art will reach his FRA and move into the third category, where he’ll stay for the rest of his life.
While you are in category one, you face a severe loss of Social Security benefits if you’re still earning income. If you are younger than full retirement age during all of 2013, the government will deduct $1 from your benefits for each $2 you earned above $15,120. That ceiling was $14,640 the year before. Once you reach your FRA, however, you can earn any amount and still receive your full benefit.
Note that these limits apply only to income from working. You can have any amount of income from interest, dividends or capital gains and still collect the Social Security benefit to which you’re entitled, as long as you don’t go over the earnings limits.
Now, it’s true that this reduction in earnings is not permanent. If some of your Social Security retirement benefits are withheld because of your earnings, your benefits will be increased starting at your full retirement age to take into account those months in which benefits were withheld. Nevertheless, these earnings tests make it less appealing to start benefits before your FRA, if you have earnings.
What if you put your earnings toward a 401(k)? Doesn’t matter. The Social Security checks will still be smaller. Yes, your contributions to the 401(k) will lower your taxable income, but it’s still your gross wages from a job or self-employment – before any deductions for taxes or 401(k) contributions – that determine whether your Social Security benefits will be reduced under the earnings cap.
The 8% Solution
From age 62 until your FRA, another set of rules will reduce your Social Security benefits, and this reduction will be permanent. In essence, the earlier you start, the smaller the benefit you’ll receive. At the time of this writing, if you start at 62, your monthly check will be only 75% of the benefit you would have received at age 66.
Suppose Beth Williams was born in 1951 so she’ll be 62 in 2013. If she starts Social Security benefits this year, the Social Security Administration will determine what her FRA would be if Beth decided to wait until her FRA. Beth will get 75% of that amount.
Say that Beth’s FRA benefit is calculated at $2,000 a month. By starting at age 62, she would get $1,500 a month – a 25% reduction in monthly income. That’s the amount Beth will receive for the rest of her life, plus any cost-of-living adjustments (COLAs).
The longer Beth waits to start benefits, the larger each check will be. She will get 80% of her FRA benefit if she starts at age 63, for example, and 86.7% if she starts at age 64.
The bottom line is that Beth (and everyone else born from 1943 through 1954) will increase her benefits by 33.3% by waiting from age 62 to age 66 to start. Instead of $1,500 a month (plus COLAs), Beth will receive $2,000 a month for the rest of her life, plus any COLAs. Thus, Beth gets a 33.3% boost in lifetime income by waiting four years to start. That’s a return of around 8% a year, on the money not requested.
I just saw a light bulb go off over many heads out there. When you think of it as a passive return on investment, it puts delaying Social Security benefits in an entirely new light. Once Beth reaches age 66, her FRA, she can earn any amount, without any reduction in benefits. There’s no reduction for starting early, either. Therefore, Beth faces no obstacles to starting her retirement benefits then.
That doesn’t mean Beth should start her benefits at her FRA. After your FRA, Social Security offers a “delayed retirement credit” of 8% a year. (Actually, the credit is 2/3% per month, after your FRA). This goes on until you reach age 70, after which there is no point in waiting any longer. Thus, anyone who reaches his or her FRA at age 66 will get a monthly check that’s 8% larger by starting at age 67, 16% larger at 68, 24% larger at 69, and 32% larger at 70.
Beth Williams, in this example, could increase her monthly check from $1,500 a month to $2,640 a month, by waiting from age 62 to age 70. She’ll collect that larger benefit, plus COLAs, until she dies. What’s more, waiting is an especially attractive strategy for a married couple. After one spouse dies, the surviving spouse will receive the higher of two benefits: the survivor’s monthly benefit or the deceased spouse’s benefit.
Suppose, for example, that Charlie Thomas waits until age 70 to start his benefits. He collects those benefits for nearly 20 years, until he is receiving more than $4,000 a month at the time of his death. Charlie’s wife Diane, who had not earned substantial amounts in her career, receives about $2,000 a month then, in this example.
After Charlie dies, Diane will collect the higher benefit – Charlie’s $4,000-plus per month – for the rest of her life. Thus, for couples where the higher-earning spouse has a shorter life expectancy, a delay in starting benefits by the higher-earner acts as a form of life insurance, payable to the surviving spouse.
Waiting until you are 70 years of age may not be possible for everyone. What if you absolutely need the money for living expenses? Then go ahead. Start your Social Security retirement benefits as soon as you can. If you have a serious health condition, you might as well start receiving benefits early, to collect while you can. Otherwise, if you are in reasonably good health – or married to a spouse with a longer life expectancy – and you have other assets you can use for spending money, it pays to wait. Uncle Sam is promising you an 8% return, with no investment risk, government-guaranteed. If you have to cash in low-yielding assets to live on, consider doing so in order to earn that 8% a year, in addition to COLAs, until you reach age 70.