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“I’d love to work part-time during retirement, but I am concerned that the government will take away my Social Security retirement benefits if I do.”
That sentiment is an alarming one to hear from a client that is already or will be soon claiming Social Security retirement benefits. Social Security is a critical piece of the retirement plans of many Americans. That said, many Americans misunderstand the specific rules that will determine their benefits. The rules are complex so this is understandable and to be expected, but it’s very important for us as financial planners to know them cold, so that we can put any misunderstandings to rest while properly advising our clients.
First, let's set the table with a few statistics from 2 resources (Social Security Fact Sheet and 2020 Social Security Changes):
- Nearly 9 out of 10 individuals age 65 and older receive Social Security benefits.
- Social Security benefits represent about 33% of the income of the elderly.
- Among elderly Social Security beneficiaries, 50% of married couples and 70% of unmarried persons receive 50% or more of their income from Social Security.
- Among elderly Social Security beneficiaries, 21% of married couples and about 45% of unmarried persons rely on Social Security for 90% or more of their income.
These statistics demonstrate why a working knowledge of Social Security is imperative for financial planners seeking to provide sound advice to clients at or near retirement age.
Below we will work through two common misunderstandings regarding Social Security retirement benefits:
- The reduction of benefits due to claiming benefits prior to full retirement age (FRA), and
- The further reduction of benefits due to earned income while claiming benefits prior to FRA.
Based on a worker’s year of birth, full retirement age currently ranges from age 65 to age 67. If benefits are claimed prior to FRA, the earliest age being 62, the benefits are reduced a fraction of a percent for each month prior to FRA. The reduction formula is 5/9ths of one percent for the first 36 months, plus 5/12ths of one percent for months 37 to 60. A taxpayer claiming benefits 36 months early will have a reduction in benefits of 20% (5/9ths of 1% x 36). A taxpayer claiming benefits 60 months early has a benefit reduction of 30% [(5/9ths of 1% x 36) + (5/12ths of 1% x 24)].
Another reduction in benefits may occur if the taxpayer claims benefits prior to FRA and continues to have earned income. For this reduction, the period from age 62 to FRA has one formula and the year in which the taxpayer attains FRA has a different formula.
In the first phase, benefits are reduced by $1 for every $2 of earned income above the threshold. In 2020, the threshold is $18,240. For example, a worker who claims benefits prior to FRA and has $25,000 of earned income will have a benefit reduction (withheld) of $3,380 [($25,000 - $18,240) / 2]. There is a special rule in the first year of retirement claiming benefits under which only the earned income after filing is considered. A worker, age 62, with $25,000 of earned income prior to filing for benefits will still receive benefits for every month remaining in the first year in which the earned income is less than $1,520 ($18,240 / 12).
In the year a worker attains FRA, the formula is less restrictive. The earned income threshold is $48,600 (2020) and the reduction is $1 for every $3 of earned income above the threshold. A worker who claims benefits prior to FRA with $50,000 of earned income has a reduction of $467 [($50,000 - $48,600) / 3]. If the year in which FRA is reached is the first year of benefits, the exception applies and only earned income that year after FRA is considered. A worker with $50,000 earned income prior to FRA can still receive benefits for each month the balance of the year in which monthly earned income is less than $4,050 ($48,600 / 12).
There is no earned income limit after a worker attains FRA. All is not lost, however, if benefits are reduced prior to FRA due to earned income. At FRA, the worker’s benefits are increased, considering the previous months in which benefits were withheld.
