For Social Security beneficiaries who decide to wait beyond their full retirement age (FRA) to claim their benefits, there is an option to receive up to six months’ worth of retroactive benefits in a lump sum payment. I was surprised to learn that this option is the default for anyone claiming their retirement benefit after FRA, unless it is expressly stated by the applicant that they do not want the retroactive lump sum option.
While this may sound like a good option and may even be presented as such by the Social Security representative entering your application, it has a few significant catches.
Downsides of This Strategy
The biggest and most important catch is that taking this option means that you will lose up to six months of delayed retirement credits (DRC). Anyone who decides to wait to claim their benefit beyond FRA receives an extra 2/3% per month of their FRA benefit amount. By taking the retroactive lump sum, you are also agreeing to receive a smaller monthly payment. Multiply the 2/3% per month DRC by six months and you get a 4% haircut on the amount you were eligible to receive. This reduction is permanent for the claimant’s benefit amount and for the surviving spouse’s Survivor Benefit amount.
If we look at just the claimant’s benefit and ignore any other factors (such as tax consequences, investment opportunity, and Survivor’s Benefits), the six-month lump sum payment equals the 4% of lost DRCs after 12.5 years: 0.50 years (6 months) / 0.04 (4%) = 12.50 years. In other words, after 12.5 years, you are losing more money than you gained. That total amount of lost benefits just gets larger each month going forward.
Another item to consider is that the lump sum payment will create a bit more work when it comes time to file your taxes if the lump sum amount includes benefits that apply to months in a previous tax year. The IRS gives you two options for calculating any tax due on the portion of the lump sum that would apply to another tax year:
- You can use your current year’s income to determine the taxable part of the lump sum, or
- You may elect to determine the taxable part of the lump sum based on your income for the earlier year, using the worksheet in IRS Publication 915.
You will want to run the numbers both ways to make sure you are not giving the government a gift in the form of paying more tax than you are required to pay.
Even if the above information has not swayed you and you’re still interested in opting for the retroactive benefits lump sum payment, remember that you were able to claim those benefits during those prior months. Since you did not claim them up to six months ago, you effectively gave the government an interest-free loan on that lump sum amount. Hence my statement that this is almost never the best strategy.
The only scenario I can think of where this may be an appropriate strategy is one in which you recently discovered your life expectancy is much shorter than you previously thought, and your spouse would not be collecting on your record after you pass away. For most retirees, this is not a scenario in which they will ever find themselves.
Claiming Your Social Security Benefits
The best claiming strategy for Social Security benefits has many variables and depends on a few assumptions. The decision of how and when to claim your benefits should be discussed with a qualified financial planner looking at the whole picture of your unique situation and working in your best interest.