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Save Soc. Sec. for Later, When You Need It Most

Tim Maurer, Director of Personal Finance

I think we’ve been looking at Social Security retirement benefits all wrong. In the long-running debate about when to take Social Security — as early as age 62 or as late as age 70 — the focus has been on timing your claim to get the most money, in total, out of the social safety net.

This is a circular argument that will never be fully decided until the Social Security recipient in question dies. So let’s shift the focus from the question “How do we get the most out of Social Security?” to “How do we get Social Security when we need it most?”

Simply put, you’re more likely to run out of money at the end of retirement than at the beginning.

Behavioral science explains why we are all so prone to preferring money today over tomorrow. It’s called “hyperbolic discounting,” and behavioral economists plead that we meaningfully overvalue money now, unfairly discounting money later.

But the risk of making less money in your early retirement years is dwarfed in comparison to the risks of longevity and inflation in the latter stages of retirement. And the probability you will outlive your money meaningfully decreases if you wait to take Social Security.

Prove it!

Let me show you through an example that, while hypothetical, is no doubt close to reality for many.

We’ll consider three couples, the Earlies, the Fullers and the Laters. Each couple:

  • Retires with $1 million in tax-deferred retirement savings.
  • Has an identical 50 percent equity, 50 percent fixed-income portfolio.
  • Has a pretax retirement income need of $90,000 per year.
  • Will supplement their Social Security income with the retirement savings necessary to fulfill their income needs.
  • Includes one household member who will receive the maximum in Social Security benefits and one who will receive 50 percent of the maximum.

The only difference is that the Earlies retire and begin taking Social Security retirement benefits at 62, the Fullers at 67 and the Laters at 70.

This hypothetical case study is designed to result in an academic probability that each couple will not run out of money, and applies more than 3,000 iterations of randomized historical market returns for the respective retirees’ portfolio allocations.

Then, we show the likelihood that each couple will have at least one dollar left in retirement savings at the end of four different time periods — 20, 25, 30 and 35 years into retirement.

Therefore, if you see a result of 47 percent in the 25-year column of the table below, it means the couple represented still had at least one dollar left in their retirement savings at the end of that period in nearly half of the thousands of iterations run. In other words, that couple had a 47 percent chance of not running out of money 25 years into retirement. Statistically, a probability of 85 percent or better is favorable.

The findings

What did we find? If you die early enough — within 20 years of your retirement date — you have a reasonably good chance to outlive your money regardless of when you take Social Security. The Earlies hit the golf course fully five years before the Fullers, but it’s not clear that they’ve suffered for it at the 20-year mark.

At 25 years, however, there’s a greater than 50 percent chance the Earlies have run out of money and now must ask their kids to pay their greens fees. At 30 years their probability of solvency has dropped to 30 percent, and at 35 years they’re likely relying on their reduced Social Security benefit for all of their income.

Why do the Earlies fail? Because in order to meet their income needs with a reduced Social Security benefit, they put too much pressure on their portfolio to pick up the tab. They were forced to take an effective withdrawal rate of 5.62 percent in their first year of retirement.

How do the Fullers look? Pretty good. Buoyed by a Full Retirement Age (FRA) Social Security benefit and beginning with a reasonable 4 percent effective rate of withdrawal from their portfolio, at 20 and 25 years into retirement, they’re in the 90 percent-plus range. But if they plan on seeing their faces on a Smucker’s jar, their probability of success declines to 67 percent when they’re 35 years into retirement.

As you’d guess, the Laters are solid. Because of their increased Social Security benefit, they require only a 3.26 percent portfolio withdrawal rate in year one. Statistically, they ride off into the sunset and should have the funds to test the boundaries of science in their pursuit of longevity.

If you suspect you’ll die early — and have lineal or medical justification for that belief — you might justify taking Social Security as early as you can (although a lesser-earning spouse could still benefit from your higher benefit when you’re gone). And please forgive the inherent insensitivity in this analysis, which presumes the Earlies, Fullers and Laters all have a choice in taking their benefits at various points in time. Many retirees don’t, and if you need to retire and take early Social Security for any number of valid reasons, of course you should do just that.

But if you hope to have a longer retirement — 30 or 35 years, especially — your chances of not outliving your retirement savings improve greatly if you delay Social Security. Waiting is like purchasing longevity and inflation insurance for what will hopefully be a long and prosperous retirement.

This commentary originally appeared January 1 on CNBC.com

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Glasses on newspaper

Can Your 401(k) Impact Your SS Benefits?

By Claire Boyte-White | Updated June 26, 2017 — 6:00 AM EDT

Reposted from Investopedia

While income you receive from your 401(k) or other qualified retirement plan does not affect the amount of Social Security retirement benefits you receive each month, you may be required to pay taxes on some or all of your benefits if your annual income exceeds a certain threshold.

Why Doesn’t 401(k) Income Affect Social Security?

Your Social Security benefits are determined by the amount of money you earned during your working years for which you paid Social Security taxes. Since contributions to your 401(k) are made with compensation received from employment by a U.S. company, you have already paid Social Security taxes on those dollars.

This holds true even for traditional 401(k) accounts. Contributions to traditional accounts are made with pretax dollars, but this tax shelter only applies to income taxes, not Social Security. While you don’t pay income tax on traditional 401(k) funds until you withdraw them, you still pay Social Security taxes on the full amount of your compensation in the year you earned it.

“Contributions to a 401(k) are subject to Social Security and Medicare taxes, but are not subject to income taxes, unless you are making a Roth (after-tax) contribution,” notes Mark Hebner, founder and president of Index Fund Advisors, Inc., Irvine, Calif., and author of “Index Funds: The 12-Step Recovery Program for Active Investors.”

The Tax Impact of 401(k) Savings

Though the amount of your benefit is not affected by your 401(k) savings, you may have to pay income taxes on some of your benefits if your combined annual income exceeds a certain amount. In fact, about one-third of benefit recipients must pay taxes on a portion of their benefits.

The income thresholds are based on your combined income, which is equal to the sum of your adjusted gross income (AGI) – which includes withdrawals from any retirement savings accounts – any non-taxable interest earned and one-half of your Social Security benefits. If you take large distributions from your 401(k) in any given year that you receive benefits, you are more likely to exceed the income threshold and increase your tax liability for the year.

In 2017, if your total income for the year is less than $25,000 and you file as an individual, you won’t be required to pay taxes on any portion of your Social Security benefits. If you file jointly as a married couple, this limit is raised to $32,000. You may be required to pay taxes on up to 50% of your benefits if you are an individual with income between $25,000 and $34,000, or if you file jointly and have income between $32,000 and $44,000. Up to 85% of your benefits may be taxable if you are single and earn more than $34,000 or if you are married and earn more than $44,000. If you are married but file a separate return, you are likely to be liable to for income tax on the total amount of your benefits, regardless of your income level.

Other Types of Retirement Income

In some cases, other types of retirement income may affect your benefit amount, even if you collect benefits on your spouse’s account. Your benefits may be reduced to account for income you receive from a pension based on earnings from a government job or from another job for which your earnings were not subject to Social Security taxes. This primarily affects people working in state or local government positions, the federal civil service or those who have worked for a foreign company.

If you work in a government position and receive a pension for work not subject to Social Security taxes, your Social Security benefits received as a spouse or widow or widower are reduced by two-thirds of the amount of the pension. This rule is called the government pension offset (GPO). For example, if you are eligible to receive $1,200 in Social Security but also receive $900 per month from a government pension, your Social Security benefits are reduced by $600 to account for your pension income. This means your Social Security benefit amount is reduced to $600, but your total monthly income is still $1,500.

The windfall elimination provision (WEP) reduces the unfair advantage given to those who receive benefits on their own account and receive income from a pension based on earnings for which they did not pay Social Security taxes. In these cases, the WEP simply reduces Social Security benefits by a certain factor, depending on the age and birth date of the applicant.

How Your Is Benefit Determined?

Your Social Security benefit amount is largely determined by how much you earned during your working years, your age when you retire and your expected life span.

The first factor that influences your benefit amount is the average amount that you earned while working. Essentially, the more you earned, the higher your benefits will be, up to the maximum benefit amount of $3,538. The Social Security Administration (SSA) calculates an average monthly benefit amount based on your average income and the number of years you are expected to live.

In addition to these factors, your age when you retire also plays a crucial role in determining your benefit amount. While you can begin receiving Social Security benefits as early as age 62, your benefit amount is reduced for each month that you begin collecting before your full retirement age. Full retirement age varies between 65 and 67, depending on your year of birth. Conversely, your benefit amount may be increased if you continue to work and delay receiving benefits beyond full retirement age. For example, in 2017, the maximum monthly benefit amount for those retiring at full retirement age is $2,687. For those retiring early, at age 62, the maximum drops to $2,153, while those who defer collection until age 70 – the latest age at which collection can commence – can collect a benefit of $3,538 per month.

“Delaying Social Security until age 70 can be beneficial since you will receive an 8% gain every year after reaching your full retirement age,” says Carlos Dias Jr., wealth manager, Excel Tax & Wealth Group, Lake Mary, Fla.

Eligibility Requirements

To receive Social Security benefits, you must have accrued 40 credits, which you earn by working and paying into the Social Security system. Each year of work is worth a maximum of four credits, so you must work a minimum of 10 years to be eligible. However, each credit is equivalent to $1,300 of taxable earnings in 2017. Once you’ve earned $5,200 in any given year, you have already earned the maximum four credits. This means you could elect to stop working for the rest of year without endangering your eligibility, though this is not a very sustainable strategy. For one thing, a lower income will mean your benefits will be lower.