On average, Social Security replaces about 40% of pre-retirement income, making it an important part of retirement planning.  As financial planners we are often asked how Social Security works, how it is calculated and the type of claiming strategy we recommend.  We wanted to cover the basics of how Social Security works but strongly advise seeing a CERTIFIED FINANCIAL PLANNER™ to discuss your situation.

History Lesson

Social Security, also known as the Old-Age, Survivors and Disability Insurance, was established in 1935 following the Great Depression.  It was intended as a safety net and meant to address the poverty of the elderly that was so devastating during the 1930’s.  For many retirees it became their primary source of retirement income.  For others it became a meaningful piece of the retirement income triad – the three parts of which were Social Security, pension, and retirement savings.  One of the great benefits of Social Security is the promise of steady, inflation-adjusted income for the rest of one’s life.

Social Security is funded primarily through payroll taxes.  The employee and the employer each contribute 6.2% of their income up to a maximum income of $132,900 in 2019.  Those who are self-employed pay the full 12.4% as they contribute both as employee and employer.  Other sources of funding include interest earned by the assets of the Trust, taxes assessed on Social Security benefits and reimbursements from the General Fund.

Determining Eligibility & Benefit Amount

96% of American workers are covered by Social Security with the most commonly excluded categories being railroad employees and federal government employees who are covered by the Civil Service Retirement System.  The eligibility requirements for Social Security are not difficult to meet.  Those who work in a Social Security covered job for at least 10 years are generally eligible for benefits.  When calculating the benefit amount Social Security considers an individual’s entire earnings record, specifically the 35 highest earning years.  They then apply the average earnings to a formula to determine the benefit estimate.  The equation used to determine the basic benefit amount is very complex and only an estimate.  The closer one is to filing, the more accurate the estimate becomes.  We recommend that our clients establish “my social security account” via the Social Security website (www.socialsecurity.gov/myaccount) and review their earnings and benefit estimate.

Once an individual reaches their full retirement age, they become eligible for their basic benefit amount.  For many years the full retirement age was 65 (the age of Medicare eligibility), however, the finish line was moved forward in 1983 requiring workers to work longer to receive their full benefits.  Knowing your full retirement age is important because your basic benefit amount will be adjusted depending on if you claim before or after this age.

Claiming Your Benefit

Social Security can be claimed as early as 62 or as late as age 70.  Upon reaching full retirement age, you are eligible to receive the basic benefit amount.  However, the timing of when you file will determine if you receive more or less than the basic benefit amount.  Delaying filing after the full retirement age will increase the benefit amount by 8% a year up until age 70- a potential increase of 32%! Conversely, filing before full retirement age will result in an amount that is lower than the basic benefit.  The most popular age for claiming benefits is 62 (chosen by 42% of men and 48% of women) yet the benefit is reduced by 30% versus the benefit if taken at a full retirement age of 67.

One of the more difficult decisions that a person faces is when to start claiming benefits.  Factors influencing this decision include the health of the individuals involved, their work status, longevity concerns, other sources of income and their financial net worth.  Helping clients make the right decision for them is an important part of our job as financial planners.

Spousal Benefits

Spouses who have little or no earnings are entitled to a spousal benefit of up to ½ the retired worker’s full retirement benefit.  If you were born after 1/2/54 and are eligible for both your own and a spousal benefit you must apply for both benefits in what is called a deemed filing. Social Security will pay the higher amount.  You cannot restrict your filing to one benefit and switch it later.

If a spousal benefit is claimed before full retirement age, it is subject to a reduced payout.  For example, if full retirement age is 66 and you file for benefits at age 62, you will receive 35% of the spousal benefit (instead of the full 50%).

Widows and widowers can begin taking Social Security benefits at age 60, or at age 50 if disabled.  The survivor benefit equals 100% of the spouse’s benefit, but it is reduced if taken before full retirement age.

Divorcees who were married at least 10 years and have not remarried may file for spousal benefits based on their ex-spouse’s work record.  The earliest that one can apply for spousal benefits is age 62 (both parties) and must be divorced at least 2 years.

Children’s Benefits

For those who had children later in life, or from a second marriage the Social Security benefits for dependent children can be significant.  Your dependent child/children may be entitled to benefits of up to ½ your full retirement benefit when you start Social Security if the following conditions are met:

• Child is unmarried and under age 18
• Child is unmarried and 18-19 and a full-time student (in high school)
• Child is unmarried, 18 or older and disabled before age 22

Working While Claiming

People who are under the full-retirement age and still working will be subject to an earnings test and may have some of their Social Security benefits withheld.  For 2019, the earnings limit is $17,640.  Earn more than this and Social Security will reduce your benefits by $1 for every $2 earned above this limit.  In the year that you turn full retirement age you can earn up to $46,920 (in 2019).  Above this amount Social Security will reduce your benefits $1 for every $3 earned above the limit.

Once you reach full-retirement age, you can earn any amount from working without a reduction in benefits.

It is important to note that the earnings test applies to spousal and survivor benefits as well, so careful consideration should be made when a decision to file while still earning income.

Taxation of Benefits 

In a particularly cruel twist, the Social Security benefits that you receive from the payroll taxes that were withheld may be taxed again when paid out as income.  In fact, about 40% of people who receive Social Security will pay income taxes on the benefits.  The threshold amounts of income were established in 1983 and have not been adjusted for inflation, so more and more retirees are finding Social Security payments subject to taxation.

• If you file a federal tax return as an “individual,” and your combined income* is between $25,000 and $34,000, you may have to pay taxes on up to 50 percent of your Social Security benefits. If your combined income* is more than $34,000, up to 85 percent of your Social Security benefits is subject to income tax.
• If you file a joint return, you may have to pay taxes on 50 percent of your benefits if you and your spouse have a combined income* between $32,000 and $44,000. If your combined income* is more than $44,000, up to 85 percent of your Social Security benefits is subject to income tax.

* On the 1040 tax return, your “combined income” is the sum of your adjusted gross income plus nontaxable interest plus half of your Social Security benefits.