In the United States, Social Security plays a significant role in our retirement system and is a component of almost everyone’s retirement planning. It is also one of the most complex programs and is rarely understood by most people.
The challenging part about Social Security is that each family has to make decisions such as when to claim benefits, whether to work a part-time job, whether to complete Roth conversions, or whether to harvest capital gains and each of these decisions are linked to Social Security in some way.
Most families ultimately make these decisions without understanding how these decisions impact their Social Security benefits. This article is the first of a two-part series that will focus on Social Security with the intention of helping families make informed decisions.
Before we can focus on the specific strategies to maximize your benefits, it is important to understand how the system works. This article will cover the basics of Social Security and how it is taxed which will provide the foundational knowledge that will be necessary to understand the strategies we will discuss in the second article.
Will Social Security Last?
Before discussing how Social Security works, let’s briefly consider one of the most common questions people ask which is whether Social Security will run out of money. While it is true that the Social Security trust fund is depleting, there is more to the story.
Current estimates are that the Social Security trust fund will be fully depleted by 2034; however, the trust fund only covers a portion of ongoing benefits. Most benefits are covered through payroll taxes that are received annually. When the trust fund is depleted, the current estimates are that 78% of current benefit amounts will still be funded by payroll taxes.
Key Takeaway:
The majority of Social Security benefits are funded by annual payroll taxes.
Benefit cuts are very unpopular, and politicians will likely be reluctant to cut benefits for those in or nearing retirement. There are many levers available for politicians to pull to avoid reducing benefits. A few potential options are:
- Removing the wage cap on earnings that are subject to Social Security taxes (capped at $147,000 in 2022).
- Increasing the Social Security tax rate from the current level of 12.4% (½ paid by employee and ½ by employer).
- Increasing the Social Security retirement age.
- Reducing benefits for younger workers while keeping benefits the same for individuals near retirement.
Our perspective is that it is much more likely for changes to be made to Social Security taxes so that benefits for current retirees and those close to retirement are not impacted with any major changes reserved to those who are younger with time to adjust.
With that primary question out of the way, let’s move on to discuss how Social Security works.
How Is Social Security Funded and How to Qualify?
Social Security is funded by payroll taxes collected on the wages of employees. Currently each employee pays 6.2% of their wages in Social Security taxes and each employer is required to match that same amount. In total, 12.4% of each employee’s wages are paid in Social Security taxes.
For an individual to qualify for Social Security benefits under their own work record, they generally need 40 credits (there are certain exceptions for death and disability). A credit is received by earning a threshold amount of income in a given year.
That threshold amount is indexed for inflation, and in 2022, it is $1,510. The maximum number of credits that can be earned in a given year is 4; so anyone who makes $6,040 in 2022 will receive 4 credits. Over the course of 10 working years, most individuals accumulate the full 40 credits.
Individuals can review their own work record to see the number of credits they’ve earned, their earnings record, and their expected benefits by creating an online account on the Social Security Administration’s website at SSA.gov.
Key Takeaway:
Individuals generally need 40 credits to qualify for their own Social Security benefit.
How is My Benefit Calculated?
Each individual’s benefit is based on how much they’ve earned each year over their lifetime which is called their work record. Because of inflation, the Social Security Administration will index each year’s earnings for inflation so that each year is shown in inflation adjusted dollars.
The Social Security Administration takes the best 35 years and calculates the average indexed monthly earnings (AIME) for those 35 years by dividing them by 420 months (35 years x 12 months = 420 months). Although the numbers and acronyms add complexity, the result is simply your average monthly earnings during your best 35 years after adjusting for inflation.
Once average indexed monthly earnings are calculated, a formula is applied to calculate the benefit that would be received as of normal retirement age. The formula includes three tiers and the portion of the individual’s average indexed monthly earnings falling within each tier is multiplied by a crediting percentage. The tiers for 2022 are:
- Less than $1,024 credited at 90%
- Between $1,024 and $6,172 credited at 32%
- Over $6,172 credited at 15%
The resulting number is the individual’s primary insurance amount (PIA) which represents their benefit if taken at normal retirement age. For example if an individual has average monthly earnings of $8,000, their normal retirement age benefit would be $2,843 as shown below:
Since each successive tier has a lower crediting rate, an individual’s benefit will increase as their average monthly earnings increase, but the rate at which their average monthly earnings translate into a higher Social Security benefit decreases. The following chart shows this effect for $1,000 increments of average monthly earnings:
Key Takeaway:
Successively higher income translates into lower increases in Social Security benefits.
How Much Will I Get?
The actual benefit you receive can vary depending on whether you claim your benefit at normal retirement age or at a different time. Normal retirement age ranges between age 65 for those born in 1937 and prior up to age 67 for those born in 1960 or later. The table below shows normal retirement age by date of birth:
If an individual chooses to start taking their benefit before or after their normal retirement age, the benefit they receive will decrease or increase accordingly. The earliest an individual can claim their benefit is age 62, and the latest they can delay their benefit is age 70.
Individuals claiming their benefit early will see their benefit reduced by approximately 0.56% per month (6.7% annually) for each month early that they claim their benefit (up to 36 months). If they claim their benefit more than 36 months prior to normal retirement age, any months over 36 will result in a benefit reduction of 0.42% (5% annually).
Individuals who delay their benefit past normal retirement age receive an increase of 0.67% per month (8% annually). These increases and decreases are permanent and will continue as long as the individual receives benefits.
The best way to demonstrate the impacts of claiming early or late is through an example For an individual who has a $1,000 primary insurance amount and a full retirement age of 67, their benefit would be the following based the age they begin taking benefits.
As shown in the graphic above, an individual with a full retirement age of 67 who takes their benefit as early as possible at age 62 accepts a benefit equal to 70% of their primary insurance amount. That’s a 30% lower benefit than they would receive if they waited until age 67 to begin taking benefits.
Similarly, an individual who delays taking their benefit until age 70 receives a benefit equal to 124% of their primary insurance amount. That’s a 24% higher benefit than they would receive if they took their benefit at age 67. In total, the increase from their age 62 benefit to their age 70 benefit is 77%.
Can I Claim Social Security While Still Working?
For individuals who want to claim their benefit early, a factor to consider is whether they are still working. Until reaching normal retirement age, individuals who are receiving benefits are limited in how much other income they are allowed to make. If they make over the threshold amounts, they will have some of their benefits withheld.
For 2022, individuals who earn over $19,560 will have $1 of Social Security withheld for every $2 they earn over the limit. In the year that the individual reaches normal retirement age, the earnings limit increases to $51,960, and they will only have $1 withheld for every $3 they make over the limit. Any amounts withheld are treated as if they were not paid and result in additional credit in the future toward a higher benefit amount.
When determining the amount of income earned, wages, bonuses, commissions, vacation pay, and income from self-employment count, but other income such as pensions, annuities, investment income, interest, or government benefits do not count. This determination is also made at the individual level; so spousal income is not included.
The bottom line is that it typically does not make sense for an individual to claim their benefit early if they are still working and making over the threshold income limits.
Can I Claim Benefits Based on My Spouse’s Record?
Individuals can qualify for spousal benefits based on the work record of their spouse if they’ve been married for at least one year. One important point about spousal benefits is that they are available even if the individual does not have a Social Security work record of their own. The non-working spouse can qualify strictly based on the working spouse’s record.
To qualify, the individual claiming spousal benefits must be age 62 and their spouse must have already claimed their Social Security benefit. The spousal benefit can be as high as 50% of the spouse’s primary insurance amount. If the individual takes their spousal benefit prior to reaching their normal retirement age, the spousal benefit will be reduced.
If the individual qualifies under their own record, they will receive their own benefit first. If their own benefit is less than the amount of the spousal benefit, they will receive the difference. In effect, they will receive an amount equal to their own benefit or their spousal benefit, whichever is higher.
If the spouse who is drawing on their own work record delays taking Social Security and receives a higher benefit, the spousal benefit does not receive a corresponding increase. The spousal benefit maxes out at 50% of primary worker’s normal retirement age benefit.
Key Takeaway:
Married individuals can qualify for spousal benefits even if they have little or no work record of their own.
What If My Spouse Has Passed Away?
When an individual’s spouse passes away, the individual will typically qualify for survivor benefits. To qualify, the deceased spouse must have had enough credits to qualify for benefits at the time of their death and typically must have been married for at least 9 months prior to passing away.
Survivor benefits are based on the benefit amount the deceased spouse was entitled to. A survivor is allowed to claim their survivor benefit as early as age 60 although claiming a survivor benefit prior to normal retirement age will result in a reduction in benefits.
If the deceased spouse claimed their own benefit early or delayed it past normal retirement age, the related increases or decreases will carryover to the survivor benefit. This is an important consideration for married couples because it often makes sense for the spouse with the better work record to delay taking their benefit because the increases will last not only for their own lifetime, but also for their spouse’s lifetime through an increased survivor benefit.
Survivor benefits reach their maximum level at the normal retirement age of the surviving spouse and are not eligible for additional increases if the surviving spouse delays taking their survivor benefit past normal retirement age.
A unique feature about survivor benefits is that the survivor has the option to claim either survivor benefits or their own benefit. By claiming one benefit, they can allow the other benefit to grow and eventually switch to the higher benefit in the future.
Key Takeaway:
Increases or decreases in Social Security benefits from claiming early or delaying will carry over to survivor benefits.
How Is My Social Security Taxed?
While the Internal Revenue Code is complex, the taxation of Social Security is even more complex than most areas. Without getting stuck in the details, the general concept is that 0% up to 85% of Social Security benefits may be taxable.
If 85% of an individual’s Social Security benefit is taxable, that simply means that 85% of their benefit is included as income on their tax return. It doesn’t mean they will pay 85% of their benefit in taxes.
The amount that is taxable depends on something called provisional income. Provisional income includes any items of taxable income as well as non-taxable interest income plus half of the taxpayer’s Social Security benefit. In simple terms, it’s all of the taxpayer’s other income plus half their Social Security.
Once provisional income is calculated, it must be compared to the following thresholds.
As provisional income exceeds the first threshold, 50% of the excess will be treated as taxable Social Security. Once provisional exceeds the second threshold, 85% of the excess will be treated as taxable Social Security. If the calculation results in a number that exceeds 85% of the Social Security benefit, the taxable amount is limited to 85% of the benefit.
An example and a graph will help clarify this effect. The example will assume that a married couple has $60,000 in Social Security benefits. The graph shows how adding non-Social Security income in $5,000 increments impacts the taxability of their Social Security.
Initially when there is no other income, the only item contributing to provisional income is half of the couple’s Social Security benefit (i.e. $30,000). None of their benefit is taxable until provisional income exceeds the $32,000 threshold. At that point, a portion of their Social Security becomes taxable which is represented by the slowly increasing taxable Social Security line.
Once provisional income exceeds the $44,000 threshold, the taxable Social Security line gets slightly steeper until it reaches $51,000 (85% of $60,000) and hits its maximum. From that point forward, the taxable Social Security line flattens out even though provisional income continues increasing.
The interesting point that this graph demonstrates is that there is a range where adding additional dollars of non-Social Security income results in more Social Security becoming taxable until the maximum taxable amount of 85% is reached. That effect is an important consideration for tax planning which is discussed next.
Key Takeaway:
Adding additional income from non-Social Security sources can cause more Social Security to become taxable.
How Does Social Security Impact Tax Planning?
As demonstrated in the graph above, adding additional income can result in more of a taxpayer’s benefits becoming taxable. This effect has important tax planning implications because adding an additional $1.00 of income can result in more than a $1.00 increase in taxable income.
This effect is called the Social Security bump zone. For taxpayers who have exceeded the second taxability threshold, adding $1.00 of additional income adds $1.85 of additional taxable income ($1.00 of income + $0.85 of additional Social Security).
Many families make costly tax planning mistakes because they don’t understand the implications of this bump zone. For example if a taxpayer is in the 22% tax bracket and they have not reached the point where 85% of their benefit is already taxable, adding $1.00 of additional income will result in an additional $0.41 of tax.
The reason is that adding $1.00 income also results in an additional $0.85 of their benefit becoming taxable. So taxable income increases by $1.85 which at a 22% tax rate results in $0.41 of additional tax even though the only actual change was that the taxpayer earned $1.00 of additional income.
So in reality, the taxpayer has a 41% marginal tax rate. That can be a costly mistake for those who think their marginal rate is simply the 22% federal tax bracket. This effect is similar for state taxes and results in an even higher combined marginal tax rate.
The graph below shows this effect for the same family that has $60,000 of Social Security benefits. The graph shows the federal tax bracket compared to the actual marginal tax rate across the spectrum of taxable income:
As the graph shows, at very low levels of taxable income, the marginal tax rate significantly exceeds the applicable federal tax bracket due to the bump zone effect. This continues until this family’s benefit has reached the maximum taxable level of 85%. When that occurs, the marginal tax bracket and the federal tax bracket converge.
Conclusion:
Social Security is a very complex system that impacts nearly all individuals. This article has covered the general concepts to help families better understand how the system works. There are many nuances and unique situations that are not covered, but the purpose was to provide a general overview to enhance each individual’s understanding of how the system works.
The next article will focus on specific planning strategies to ensure you get the most out of your Social Security benefits, and the foundational knowledge gained from this article will be helpful in understanding the strategies in the following article. If you are interested in having a Family CFO assist you in creating a comprehensive financial plan including how to maximize your Social Security benefits, we would love to connect to see if what we do is right for you.
