“It ain’t what you don’t know that gets you into trouble,” quipped Mark Twain. “It’s what you know for sure that just ain’t so.”
The spirit of this quote recently hit me like a bag of cement. I was reading a policy briefing put out by the Washington DC based think tank, The American Enterprise Institute. (Andrew G. Biggs, “The Social Security Earnings Test: The Tax That Wasn’t,” AEI Press, July 2008) The topic was Social Security and the author was Andrew G. Biggs, a former deputy commissioner at the Social Security Administration. In particular, the focus was on Bigg’s beef with financial advisors and the SSA’s bureaucrat’s around our pontification on the earnings test for early retirees.
You see, we financial planners have been taught and we in turn teach the public and our clients to avoid the early retirement earnings penalty should they elect to take benefits prior to their full retirement age. In 2008, if one earns more than $13,560, the Social Security Administration will reduce one’s check $1 for every $2 earned over this amount. We treat this like a harsh tax and often suggest that people who semi-retire prior to full retirement age carefully calibrate their earnings to avoid this reduction. (At full retirement age, there is no test and no penalty.)
This is true as far as it goes. The problem is that it neglects what a famous radio personality Paul Harvey dubbed, The Rest of the Story. Although the Administration may reduce a person’s social security check while they are working, Biggs points out that their benefits beginning at full retirement age will be recalculated to take into account the months where the check was reduced The benefit will be higher forever, compounding from the higher base.
“At full retirement age,” writes Biggs, “Social Security not only stops withholding benefits but increases monthly benefits to replace those taken by the earnings test.” This amount will not exceed the amount that the individual would have received had they waited until full retirement age to begin taking social security.
This is hugely important. For many Americans, Social Security is their largest check in retirement. It is a lifelong annuity that arrives with a cost of living inflator. We know that the longer a person delays taking benefits, the larger the check. The problem: most people want the money as soon as possible or simply need it. They may cut back on work they would otherwise enjoy or undertake, not wanting to have their social security checked reduced because they work.
There are certainly many financial planning and tax factors that must be considered—and you should consult with a qualified tax advisor to run the cost benefit analysis on any scenarios that you may consider.
The tradeoffs include both leisure and mortality risk. By leisure risk I mean that if one elects to continue working they must, well, work, which means giving up time that could have been spent doing something else. If one wants to quit and do something else—and can afford to do so—working for more money now and more money later may not make sense.
There is also mortality risk. If one expects that their life expectancy will be truncated due to health factors, it may make financial and lifestyle sense to take the money as soon as possible. Again, a qualified professional can assist with breakeven calculation. MetLife has created such a calculator—its Social Security Decision Tool. (http://www.metlife.com/Applications/Corporate/WPS/CDA/PageGenerator/0,4773,P17259,00.html)
For many people I think knowing that they are not actually losing benefits if they earn more than the threshold will provide peace of mind and flexibility. A person, for example, can turn on the benefits they need or want starting at age 62. If they earn less than the threshold, they keep all the money. If they earn more, they will be trading earned income today for Social Security income, knowing that the Social Security will recalculate benefits at the later retirement date.
The flipside of mortality risk, after all, is longevity risk—that is, living longer than our life expectancy. With our lives extending well into our 90s for many people, retirees simply can’t have too much money. One’s paycheck can never be too large. Understanding the earnings test and the recalculation of benefits at full retirement may just help some people make that check larger.