Retirement is the goal that most of us look forward to at the end of our career. There is much debate about whether Social Security is already bankrupt or will be completely defunct by the time you are eligible to draw retirement benefits. However, with an estimated 10,000 Baby Boomers per day turning 66 and entering the official “retirement age”, consulting with clients about the best options for them related to drawing their Social Security retirement benefits is a very common occurrence.
As CPAs, we all know the fundamental rules related to Social Security retirement benefits such as: you have to earn credits during your working career, you must be at least 62 and you will get a larger benefit if you delay when you start to draw the benefits. If you are not familiar with these basic concepts, you may want to read the two earlier articles published here in CPA Magazine.
The fundamentals of qualifying for retirement benefits begin with the fact that a person must (in most cases) be at least age 62 and must have earned 40 or more “Social Security Credits” (SSC). In 2014, one SSC can be earned for each $1,200 earned. A maximum of four SSCs can be earned in any calendar year.
A second important factor is to understand “full retirement age” (FRA). Full retirement age is the age at which a person may first become entitled to full or unreduced retirement benefits. If a person was born in 1937 or before, the FRA is age 65. If a person were born in 1960 or later, then the FRA is age 67. Those born between 1943 and 1954 have a FRA of 66. Your FRA varies between those ages if you were born between those dates. The SSA site http://www.ssa.gov/retire2/retirechart.htm#chart allows people to see what their FRA is based on their birth date.
SSA has a booklet, When to Start Receiving Retirement Benefits, that is available at http://www.ssa.gov/pubs/EN-05-10147.pdf. If someone’s FRA is age 66, they can start receiving retirement benefits at age 62 and will get 75% of the monthly benefit because they will be getting benefits for an additional 48 months. If this same person starts receiving their retirement benefits at age 65, they will get 93.3% of the monthly benefit because they will be getting benefits for an additional 12 months. A link to a web page on the SSA site shows what the reduction in retirement benefits will be based on when a person decides to start receiving them.
The next element to understand is that an SSA retirement benefit is based on that person’s earnings history; basically a person’s entire working career. A retirement benefit is based on a person’s highest 35 years of earnings. I have had some clients who have focused on keeping their earnings low throughout their working career to then be surprised when they go to apply for SSA retirement benefits that they will receive a very low benefit. It is a common misconception that retirement benefits will be based on the most recent few years or perhaps the best five years of earnings.
I find this discussion to be a difficult one no matter what age the client is at the time. It seems the younger the client, the more skeptical they are that Social Security will be there for them. Then on the other hand, when clients get closer to the age when they want to draw their retirement benefits, they are disappointed that they will be receiving a smaller amount than they expected due to their own tax planning to pay as little Social Security as possible. It is frequently important to remind the client that, “Social Security was never intended to be your sole source of retirement income”.
The next key element to understanding how much you will receive for retirement benefits is the Primary Insurance Amount (PIA). The Social Security Administration (SSA) defines it this way:
“‘The primary insurance amount’ (PIA) is the benefit (before rounding down to next lower whole dollar) a person would receive if he/she elects to begin receiving retirement benefits at his/her normal retirement age. At this age, the benefit is neither reduced for early retirement nor increased for delayed retirement.
“For an individual who first becomes eligible, old-age insurance benefits in 2014 will be the sum of: (a) 90 percent of the first $816 of his/her average indexed monthly earnings, plus (b) 32 percent of his/her average indexed monthly earnings over $816 and through $4,917, plus (c) 15 percent of his/her average indexed monthly earnings over $4,917. While the percentages of this PIA formula are fixed by law, the dollar amounts in the formula change annually with changes in the national average wage index. These dollar amounts, called "bend points," govern the portions of the Average Indexed Monthly Earnings (AIME).”
The SSA explains the importance of the Average Indexed Monthly Earnings (AIME) this way:
“When we compute an insured worker's benefit, we first adjust or ‘index’ his or her earnings to reflect the change in general wage levels that occurred during the worker's years of employment. Such indexation ensures that a worker's future benefits reflect the general rise in the standard of living that occurred during his or her working lifetime.
“Up to 35 years of earnings are needed to compute average indexed monthly earnings. After we determine the number of years, we choose those years with the highest indexed earnings, sum such indexed earnings, and divide the total amount by the total number of months in those years. We then round the resulting average amount down to the next lower dollar amount. The result is the AIME.”
The amount of retirement benefit a person will receive from the SSA is based on a person’s historical earnings, or more specifically, the “average indexed monthly earnings” (AIME). The calculation of your AIME is a four-step process:
1) Adjust your earnings from prior years to today’s dollars.
2) Select the 35 highest-earning years.
3) Add up the total amount of earnings in those 35 years, excluding any earnings for each year that were in excess of the maximum amount subject to Social Security tax.
4) Divide by 420 (the number of months in 35 years).
The SSA can calculate this for a person. It is, however, important to understand the concept so that you can understand how the benefit is calculated. Also there are software programs available to help with the calculations that are discussed later in this article.
See www.cpamagazine.com for spousal benefits, couples strategies and more.
Another factor that comes to light in this equation is that if you have fewer than 35 years in which you earned income subject to Social Security taxes, the calculation of your average indexed monthly earnings will include zeros for those years. If you have a client who this applies to then it may be beneficial for them to delay when they apply for retirement benefits, and work a few additional years to replace those zero-earnings years with higher earnings. The result may not make a drastic increase, but it is a strategy that may be worth including in your discussion with the client as you evaluate their overall retirement income. Again, the use of a software program will be of great benefit to determine the increase to their retirement benefit based on the additional earnings.
For the inquiring minds among the Baby Boom generation, a person retiring in 2014 who has been able to record the maximum earning for the minimum of 35 years, their retirement at their FRA of 66 would be $2,642 per month. If your spouse files for spousal benefit based on your record (50% of yours) the maximum they would receive is $1,321. This would give the couple a combined retirement benefit of $47,556.
Up until a few years ago the SSA would mail an annual benefit statement, which contained a summary of an individual’s earnings history and estimated retirement benefits at various ages. However, in 2011 SSA suspending mailing these due to a combination of the cost to mail them and concerns over identity theft. However, you can still get this information by going to the following the instructions at: http://www.socialsecurity.gov/myaccount/. The client should set up their online access or go into an SSA office to obtain the most accurate and dependable way to ascertain a solid estimate of their retirement benefit.
Of course, the closer the client is to applying for their benefit the more accurate this will be. But sometimes it can be beneficial for a client to take a look at this information as much as 10 to 15 years from when they expect to retire especially if they have some degree of control over the amount of income they receive.
For a more detailed discussion of spousal benefits, you should read the article published on this topic earlier by CPA Magazine. However, as a very short refresher a spouse is entitled to a retirement benefit based on the larger of their own earnings record or 50% of their spouse’s record. The spouse must be at least 62 or have a qualifying child under their care. If the spouse begins to draw the benefit prior to their own FRA, they will receive a reduced benefit. However, if a spouse is caring for a qualifying child, the spousal benefit is not reduced.
In order for a spouse (Bill) to make a claim on their spouse’s (Jane) record that spouse (Jane) must have already filed for her own benefits. Furthermore, if a Bill files for retirement benefits based on Jane’s record prior to his FRA, it is considered that he has filed on both his own record and Jane’s. Bill would then receive the larger of his own or half of what Jane’s is entitled.
With this foundation, we can begin to discuss strategies on how to maximize the retirement benefits. Much of the following discussion is based on what a person considers their life expectancy to be. Very fundamentally, the longer the client expects to live the more benefit there will be from delaying when they apply for their SSA retirement benefits. Or to refine this fundamental concept if they are married, they should consider the life expectancy of both spouses as they develop their strategy. According to SSA statistics, life expectancy for a 62 year old is age 81.4 for a man and 84.3 for a woman.
Strategies for Couples
Similar to a single person, the starting point is based on life expectancy but instead of just the one person, you need to consider the life expectancy of both spouses. Basically a married couple will maximize their joint retirement benefit over their joint life expectancy if they coordinate the dates they begin drawing retirement benefits. The primary goal is to boost the benefit for the surviving spouse, since the surviving spouse will get greater of 100% of the higher earner's benefit or their own benefit. The benefit will include any of the higher earner's delayed retirement credits and cost-of-living adjustments.
According to research by William Meyer and William Reichenstein, principals of the consulting firm Social Security Solutions, “One of the most important rules of thumb for most married couples: If just one spouse is expected to live well beyond age 80, the couple's cumulative lifetime benefits will usually be highest if the higher earner delays claiming his benefits until 70”.
One hitch to a spouse drawing their retirement benefits based on the other spouse is that the other spouse must have already begun to receive their benefits. Based on the strategy the higher wage earning spouse delays until age 70 to begin drawing their retirement benefit to allow the maximum benefit over the joint life expectancy. So the solution would be for the higher earning spouse to file for their benefit which would allow the low earning spouse to begin drawing based on their higher record. Then the higher earning spouse will suspend their benefits which will allow their benefits to increase to the maximum amount allowed at age 70.
Restricted Application Strategy
At FRA, a married couple has the option of claiming the higher of their own record or half of the spouse’s benefit. When both spouses have similar earnings records but Jane is slightly higher than Bob, then at FRA, Jane files Restricted Application for just her “spousal benefit” and then at age 70 Jane files to claim on her own retirement benefit. By doing this, they are able to receive Bob’s full benefit from his FRA and Jane can claim on his record to receive 50% of that amount. Meanwhile, Jane’s benefit is increasing up to age 70 so that her retirement benefit will be larger.
File and Suspend
In this option, assume that Jane is the higher wage earner. For Bill to receive benefits based on Jane’s record, she must have filed for her own benefits. So in this strategy, Jane files to receive her benefits so that Bill can file and receive a benefit based on 50% of her benefit. But Jane wants to allow her benefit to increase to the max at age 70. So immediately after filing for her benefits, Jane files to suspend her benefits. This way Bill is allowed to receive a benefit based on her record and Jane is allowed to wait until she is 70, which allows hers to grow to the maximum amount. This will generally be beneficial when the higher wage earner has a PIA that is two and half times greater than the other spouse.
Combining Restricted Application with File and Suspend
In this strategy, both spouses make about the same amount and are both about the same age. Jane files and suspends her benefits so her benefits will increase until she turns 70 when she will start taking payments. This will allow Bob to file a restricted application at FRA for spousal benefits only based on Jane’s record. Then at age 70 they both apply to receive their full benefits based on their own records which have incremented to the maximum allowed. This strategy is especially attractive to spouses very similar in age with earnings very similar in amount and both may have long life expectancy.
Summary: Six Fundamental Rules of Thumb
1) The longer your life expectancy – it is better to delay when you begin to draw your SSA retirement.
2) For a single person who will be applying for SSA retirement based solely on their own record and is considering whether to start at 62 or as late as age 70 – break-even is approximately age 80.5.
3) Married couples benefits from having the higher earning spouse to delay, assuming either spouse will live beyond 80.5 or 85 depending on estimated inflation.
4) For married couples having the lower earning spouse to delay, only increases the amount received while both spouses are alive.
5) Combining File/Suspend with Restricted Application can produce a very attractive outcome.
6) However, the higher estimated after inflation rate of return you can earn on your investment portfolio the better it would be to begin drawing your SSA retirement earlier than later.
The important thing for CPAs as financial planners is to know the fundamentals as outlined in this article. You may be well served to invest in one of the following tools. Some of the resources below are free but most of them will require you to purchase a license. However, using one of these tools can give you confidence that you have considered the best available options.
Tools to use in Planning for Social Security
- Social Security Analyzer by Social Security Solutions
- Maximize my Social Security by Economic Security Planning, Inc.
- Social Security Administration
- Life Expectancy Calculator-SSA site
- Social Security Timing