The Bogleheads' Guide to Retirement Planning (30 page)

Calculating the exact amount of your benefit subject to federal income taxation takes some doing. Fortunately, tax preparation software such as TurboTax or TaxCut will do all the work. Following are the steps usually needed, omitting a few refinements that are rarely encountered.

First, let’s note some special items used in the computation:

The computation goes like this (did we mention that it’s very complex?):

 

Putting all this together,
Table 11.4
goes through all the steps in a sample calculation of taxable Social Security benefits.

Table 11.4
is adapted from an example in the 2008 edition of IRS Publication 915, at
www.irs.gov
. Publication 915 is an excellent source of information on the details of Social Security benefit taxation.

Income to Social Security was about $820 billion in 2009. Most came from payroll taxes paid by workers and their employers. During 2009, employers and employees each were taxed at 6.2 percent on wages up to $106,800.

Source:
IRS Publication 915

Additional income comes from interest on trust fund assets and from part of the income taxes that get paid on Social Security benefits.

Expenditures from Social Security were about $680 billion in 2009. That covered benefits to 50 million people, plus the cost to administer the program. Administrative expenses were a little under 1 cent for each dollar of benefits paid.

Any excess of income over expenditure, currently about $140 billion per year, goes into the Social Security trust funds. These funds amount to more than $2.4 trillion at the end of 2008. They are invested in a special type of U.S. Treasury bond underwritten for the fund. Treasury uses this money to pay for other government programs, while crediting interest on the bonds held in the trust funds. In other words, the cash is spent as soon as Treasury gets it, and Social Security holds a growing stack of government IOUs.

Social Security’s cash surplus makes a large contribution toward reducing the government’s annual budget deficit. The bonds in the trust funds simply represent Treasury’s promise to repay the borrowed cash whenever Social Security needs the money.

Although the thought of the government taking all the money out to pay for other programs sounds ominous, the process is not much different from any pension fund that invests in U.S. Treasury securities as part of an asset allocation. The money invested in Treasury bills, notes, and bonds goes to fund the day-to-day business of the government.

Social Security’s official annual projections of long-range income and expenditures indicate trouble ahead. The best actuarial estimates show expenditures rising rapidly, exceeding income after 2016. From that point on, Social Security will need increasingly large amounts of cash from Treasury to pay benefits. By about 2037, Treasury will have repaid all the money borrowed from Social Security; that is, the trust funds will be used up. After that, under current law, Social Security income would be enough to pay only about 74 percent of the scheduled benefits.

Causes of the long-range financial problems are mainly demographic. Large numbers of baby boomers born between 1946 and 1964 are reaching retirement age over the next two decades, while relatively few young people are entering the workforce. At the same time, the longevity of retirees is gradually increasing. As a result, the number of workers for each Social Security beneficiary is expected to shrink from 3.3 in 2009 to 2.2 in 2030 and to stay at about that level indefinitely. More information on the health of Social Security and Medicare can be found at
www.ssa.gov
.

A strong economy helps Social Security’s finances by boosting the number of workers, their wage levels, and their payroll taxes. Unfortunately, economic downturns have the opposite effect on Social Security. Also, Treasury had to meet huge demands for funds to help the economy recover from the recession in 2008 and 2009. Meanwhile, Medicare’s financial problems are much larger, more urgent, and harder to fix than Social Security.

There’s virtually no chance that Congress will let this popular program run out of money to pay scheduled benefits. Social Security will get fixed, though the timing and methods may fall within a wide range. Social Security reform is better done sooner than later. However, that will require political leadership to form a consensus in Washington, and there has not been any on this issue in recent years.

Possible reforms include higher full retirement ages, gradual reductions in the growth of benefits with inflation, tax increases on employers and workers, means testing to reduce or eliminate benefits to high-net-worth individuals, and even general-revenue subsidies from Treasury. Diverting Social Security funds into the stock market has also been discussed, but it is not popular. Benefits for existing retirees will probably be protected against reduction.

Social Security retirement benefits can begin at any age from 62 to 70. Lifetime benefits go up each month you wait. This section explains how you can increase your monthly benefit as a worker or spouse for the rest of your life by waiting to apply.

Workers and their spouses may receive retirement benefits as early as age 62. Surviving spouses can begin benefits at 60. Benefits are permanently reduced if they begin before full retirement age. The amount paid at age 62 to a worker or spouse born after 1959 is 30 percent less than the full benefit. The comparable reduction for a surviving spouse is 28.5 percent.

If you were born after 1942, your basic benefit increases by a delayed retirement credit of 8 percent for each year that you wait past full retirement age, up to age 70. Years ago, when the credit was only 3 percent for each year you waited, it made perfect sense to start benefits by your normal retirement age or before. Despite what you may have heard, that’s no longer true, especially with retirees living longer than ever.

The delayed retirement credit is on top of the automatic cost-of-living adjustments that are added to your available benefit each year after age 62 while you’re waiting. There is nothing to gain by waiting beyond age 70, so it’s essentially mandatory for you to start benefits by age 70.

Benefits to a spouse or surviving spouse are computed from the basic benefit earned by the worker married to that spouse, including any credit for delayed retirement. So a married couple can both gain when one of them waits until 70 to build up a larger benefit.
Table 11.5
shows the percentage of your basic benefit that’s available if you apply either before or after full retirement age.

Suppose you were born after 1959 and your estimated basic benefit is $1,000 a month at your full retirement age of 67. The last line in the table indicates that your benefit at age 62 would be $700 and that it would be $1,240 if you waited to age 70. The increase would be even more if additional earnings, credited while you’re waiting to apply, increase your basic benefit.

One of the most asked questions is “When is the best time to apply for Social Security benefits?” There is no simple answer to that question. First, you need to decide when you have enough financial resources to retire and are comfortable about taking that big step. Do not quit work and apply for Social Security before doing the math because you may discover that your benefit does not provide enough money. Of course, many workers have little choice about when to stop working because of poor health or job loss.

You can start Social Security as early as age 62 and get lower monthly payments for life or start as late as 70 and maximize your monthly payments. Each month you wait between 62 and 70 increases your monthly benefit. Whether you start early or late, your lifetime benefits, including cost-of-living increases, have about the same expected value. If your wife or husband receives a benefit as your spouse or surviving spouse, that amount will be based on your benefit. Still, as discussed in the following, your own situation may make a difference:

Source:
2008 OASDI Trustees’ Report, Table V.C3

The following are strategies for individuals and married couples to consider in deciding when to start their Social Security benefits. Some of these approaches take advantage of little-known SSA rules for claiming benefits as a worker or spouse. The discussion here assumes no change in the 2008 Social Security program or federal income tax code.

Some workers want to retire as soon as Social Security is available. But if you’re in good health, consider waiting past 62 before applying for Social Security so you can build up more retirement income. Many retirees live into their 80s and 90s, when Social Security may provide most or all of their income. This is especially true for women, who have a longer life expectancy than men. However, a married spouse with relatively low Social Security benefits is an exception to this rule if she would later get a larger spousal benefit anyway.

Another exception is an unmarried worker with below-average life expectancy and earnings. The shorter your life, the more it pays to start benefits as soon as possible. You also may make out better from the partial tax-free treatment of Social Security benefits.

Simply begin Social Security when you quit working full-time regardless of age (if you are age 62 or older). It makes sense for many workers who know when they can afford to retire and don’t want to use some other strategy explained here.