What to Know Before Drawing Social Security Benefits

Fixing Social Security continues to be a hotly debated issue in Congress. Each year, the Trustees of the Social Security and Medicare funds report on the programs’ current and projected financial status. Both programs face long-term financing short­falls. Employment, earnings, interest rates, and GDP dropped substan­tially in the second calendar quarter of 2020 and may not rise toward full recovery until 2023. Based on the 2021 report, the Old-Age and Survivors Insurance (OASI) Trust Fund, which pays retirement and survivors benefits, will only be able to pay scheduled benefits on a timely basis until 2033. At that time, the fund’s reserves will become depleted, and continuing tax income will only be able to pay 76% of scheduled benefits.¹

Given the bleak outlook for Social Security, many Americans reaching age 62 think the best move is to claim Social Security benefits as soon as they become eligible. This might not be the wisest choice, however, and concerns about the stability of the Social Security system should not be your main consid­er­ation. The decision to begin taking benefits at age 62 or wait until 70 is compli­cated. The impli­ca­tions of drawing benefits will play a big part in your tax planning and deciding when to draw on your retirement accounts. You will need to do careful tax projec­tions to determine how benefits will affect the taxation of your other income. This planning can help minimize taxes on Social Security benefits and maximize Social Security payments to supplement your retirement income.

Here are some things to think about as you consider the timing of drawing benefits:

1. You need to be employed and subject to Social Security taxes for 40 quarters to be eligible for benefits. Social Security will use the highest 35 years of earnings from 1951 to compute the average indexed monthly earnings. If you do not have 35 years of earnings, a zero will be entered for any remaining year to reach a total of 35.
   
   
2. If you draw Social Security benefits early, the arrangement is as follows. Your benefits are reduced 5/9 of 1% for each month before the normal retirement age, up to 36 months. If the number of months exceeds 36, the benefit is further reduced 5/12 of 1% per month. On the other hand, if you delay drawing benefits beyond your full retirement age, you will see an increase of 8% a year until age 70.
   
   In this way, the Social Security system is designed to approx­imate equal benefits for all recip­ients no matter when they start taking them. A worker with a longer life expectancy might be advised to delay collecting benefits until age 70. Those with a shorter life expectancy may want to start drawing benefits early. This depends on your retirement portfolio and general financial situation.
   
   
3. The biggest downside to drawing early applies if you are still working. Your benefits will be severely penalized if you are younger than age 66 and 10 months (the full retirement age for 2021). Before this age, tax penalties are applied to any earned income (W2 wages or self-employment income) above $18,960. Every additional $2 earned will cause you to lose $1 of benefits. In the year you reach full retirement age, the penalty changes to a $1 deduction in benefits for every $3 earned above $50,520.
   
   
4. Regardless of what age you begin collecting Social Security, your benefits may be subject to income tax. The percentage of benefits subject to tax is based on your adjusted gross income (AGI) plus tax-exempt income according to the following schedule:
   
   50% of your benefits will be taxed if your income plus half of your benefits exceeds these adjusted base amounts:
   
   • $25,000 if single, head of household or quali­fying widow(er)
   • $32,000 if married, filing jointly
   
   85% of your benefits will be taxed if your income plus half of your benefits exceeds these adjusted base amounts:
   
   • $34,000 if single, head of household, or quali­fying widow(er)
   • $44,000 if married, filing jointly
   
   Knowing how Social Security benefits are taxed helps us devise strategies to minimize the taxation of those benefits. (Part 2 of this newsletter series discusses strategies for reducing taxes on Social Security benefits.)
   

In general, you may want to consider drawing Social Security benefits early if you believe the financial challenges facing the system will adversely affect your benefits; you are unsure about the length of your life expectancy; or you would like to preserve your retirement savings.

You could consider drawing Social Security benefits later if you will be continuing to work and have earned income between age 62 and full retirement age; you come from a family with longer life expectancies; or you believe your spouse may outlive you and you want to provide them with a greater amount of your benefit.

The decision about when to start taking Social Security benefits is even more critical today than it was a couple years ago. You can no longer stop drawing benefits and then restart them later at the higher current rate by repaying the benefits you received to that point. The Social Security Admin­is­tration issued a regulation in 2010 that effec­tively limits the option to “restart” Social Security benefits. There is one eligible lifetime restart, which must take place within 12 months of claiming the initial benefit.Knowing how Social Security benefits are taxed helps us when devising strategies to minimize the taxation of those benefits. In next week’s newsletter, I will discuss strategies for minimizing the tax on your benefits.

See Part 2 and Part 3 in this series.

Rick’s Insights

• A decision to start drawing Social Security benefits early shouldn’t be made solely out of concern for the system’s solvency.
• Signif­icant tax penalties are levied against a person receiving benefits before full retirement age if they have earned income higher than $18,960.
• Tax planning plays an important role in knowing when to draw benefits, and careful projec­tions should be run beforehand.

Origi­nally Posted: June 6, 2012