What You Need to Know Before Taking Social Security Benefits – Part 1

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The payroll tax break was hotly debated early this year. Under the Middle Class Tax Relief and Job Creation Act of 2012, workers will continue to pay a lower social security tax withholding rate of 4.2 percent (down from 6.2 percent). The reduced rate was originally in effect for all of 2011 and has now been extended through the end of 2012. While this is good news for American workers, it is bad news for the Social Security trust fund. Last year the trustees of the Social Security fund estimated the fund would run out of money in 2036. Experts believe the payroll tax cut will knock three years off that projection.

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 and concerns about the stability of the Social Security system should not be the main factor. The decision to wait until age 70 or to begin taking benefits at 62 is complicated. The implication of drawing benefits plays a big part with your tax planning and how you will choose to draw on your retirement accounts. Tax projections will need to be done to determine how benefits will affect the taxation of your other income. Careful planning can make all the difference in minimizing taxes on Social Security benefits and ensuring that you receive the maximum from Social Security to supplement your retirement income.

You can still begin drawing benefits at age 62 even if your full retirement age is 66. To be eligible for benefits, a worker needs to be employed and subject to Social Security taxes for 40 quarters. Social Security will use the highest 35 years of earnings going back to 1951 to compute the average indexed monthly earnings. If a worker did not have 35 years of earnings, a zero would be entered for those years to reach a total of 35. A worker who chooses to retire at 62 will receive a reduced benefit by approximately .56% for each month before their normal retirement age. Those who delay drawing benefits beyond their full retirement age will see an increase of about 8% a year up to 140% of the normal benefit.

The Social Security system was designed to approximate equal benefits for all recipients no matter when they start taking them. A worker with a longer life expectancy might be well advised to delay collecting benefits until age 70. Those with a shorter life expectancy may want to start benefits early. In reality this depends on your retirement portfolio and general financial situation.

The biggest drawback to drawing early is for those who are still working. Benefits are severely penalized if you are younger than age 66 (which is considered full retirement age this year). Before age 66, tax penalties are applied to any earned income (W2 wages or self-employment income) above $14,640, so that for every additional $2 earned will cause you to lose $1 of benefits.

Regardless of what age you begin collecting Social Security, your benefits may be subject to income tax. While all Social Security benefits are subject to income taxes—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 benefits taxed.This is the amount of benefits that will be taxed if your income plus half of your benefits exceeds these base amounts:
    • $25,000 if single, head of household or qualifying widow(er)
    • o $32,000 if married, filing jointly
  • 85% of benefits taxed.This is the amount of benefits that will be taxed if your income plus half 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 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.

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

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

The decision when to start taking your Social Security benefits is even more important today than it was a couple of years ago. You can no longer stop drawing your benefits and then restart them later at the higher current rate by repaying all of the benefits you’ve received to that point. The Social Security Administration issued a regulation in 2010 that effectively limits the option to “restart” Social Security benefits. You are now limited to one restart in a lifetime and the restart must take place within 12 months of the initial benefit claiming.

See Part 2 and Part 3 in this series.

Rick’s Insights

  • A decision to start drawing Social Security benefits early should not be made solely out of concern for the solvency of the system.
  • Significant tax penalties are levied against a person receiving benefits before full retirement age if they have earned income greater than $14,640.
  • Tax planning plays an important role and projections should be run before you begin drawing benefits.

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