Social Security and Your Retirement Benefits

Regardless of one’s life experiences, nearly every American can expect to receive Social Security benefits in retirement.  But how much you’ll receive depends on a number of complicated and interdependent factors.  Today, let’s talk about how Social Security benefits are calculated, the tax you may have to pay upon receiving them, and different actions you can take to increase your Social Security payments.

How Much Social Security Will I Receive?

Broadly speaking, your Social Security benefits are a function of how much you earned during the years you worked while contributing to Social Security. The Social Security Administration (SSA) takes your top 35 highest-earning years, adjusted for inflation, to calculate your average indexed monthly earnings (AIME). Only income up to the maximum taxable earnings amount is counted.  For 2021, the max is $142,800. If you worked less than 35 years, Social Security credits you with zero income for all the years less than 35 that you worked.   This information is used to calculate your primary insurance amount (PIA). This is the amount you’ll receive if you begin to draw Social Security at your Full Retirement Age (FRA).  Your FRA will be between 66 and 67, depending on when you were born, with younger people having a later FRA.  You can begin to draw Social Security before you reach your FRA, but it’ll cost you: if you start to take benefits at age 62 (earliest possible age), with an FRA of 66 your benefits will decrease by 25%, and with an FRA of 67 your benefits will decrease by 30%.   Conversely, if you delay taking Social Security past your FRA, your benefits will increase by 8% per year.  

Once your PIA is calculated and you know your FRA, allowing you to calculate your expected monthly benefits, your payments will increase annually by a Cost of Living Adjustment (COLA). The COLA is based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).  The COLA is designed to help prevent the purchasing power of your benefits from being eroded by inflation.  

If you’d like to work through a concrete example to estimate your benefits, HCM can help with specialized Social Security planning tools, or you can use the Social Security Retirement Estimator.

Tax Planning and Retirement Benefits

Most people receiving Social Security pay taxes on their benefits because their combined income from Social Security and other income sources has crossed the threshold where taxes kick in.   However, there are steps you can take to help minimize this tax burden.

Social Security has been taxable above certain income levels since 1983.  Unfortunately, the law enacting these taxes didn’t include adjustments for inflation, so as benefit totals increase, more people become subject to these taxes.

A maximum of 85% of one’s Social Security benefits are potentially subject to taxation.  To calculate how much is taxable, the IRS starts with your adjusted gross income (AGI) then adds tax-exempt interest and half your Social Security benefits.  If this combined income is between $25,000 and $34,000 for an individual filer ($32,000 and $44,000 for a married couple) you could pay taxes on up to half of your benefits.  If your income exceeds $34,000 as an individual ($44,000 for a married couple), you could be taxed on up to 85% of your benefits.   

So, what can you do about this? One tactic is to fund a Roth IRA in your working years and use it for retirement income.  Because Roth IRA contributions are made with after-tax dollars, there are no taxes applied when funds are withdrawn.  This means you won’t owe taxes on these distributions when you take them, provided you’re more than 59 ½ years old and the money was in the account for at least five years.  Funding Roth IRAs rather than Traditional IRAs depends on a variety of tax related factors that go beyond the taxability of Social Security benefits.  This is a strategy that you may want to discuss with your HCM Advisor.

Another possibility is to withdraw income from an IRA, 401(k), etc., before beginning to draw Social Security.  It’s normally best to wait until after you’re 59 ½ to begin IRA distributions to avoid penalties for early withdrawals.  You shouldn’t do this until you’ve considered your complete tax picture for the foreseeable future.  Your goal is to minimize your total lifetime tax burden. If your situation fits this strategy, you may enjoy multiple benefits: first, by taking the IRA distributions and delaying Social Security, you’re allowing your Social Security benefits to increase.   Also, drawing down your tax-deferred accounts before you turn 72 decreases the total Required Minimum Distributions (RMDs) you’ll have to make as well as the taxes you’d have to pay on those distributions. Note that this is not a one-size-fits-all solution; talk to an Advisor to see if this strategy makes sense for you.

Those taxpayers eligible to make charitable gifts via Qualified Charitable Contributions that reduce their Required IRA distributions can use this strategy to reduce adjusted gross income and potentially the tax owed on Social Security benefits.

Benefits Reductions

If you begin to draw benefits before your Full Retirement Age while you’re still working, you will see a adjustment in your benefits if you earn above the annual limit.  For 2021, the annual limit is $18,960. If you do earn income above that level, the Social Security Administration will deduct $1 of benefits for every $2 earned above the limit. You will receive an offsetting adjustment in future years.   You will also see an adjustment in benefits if you earn too much and claim benefits in the year you reach Full Retirement Age.  The limit is $50,520 for 2021, and they only count earnings before the month you reach your full retirement age.  Once you reach Full Retirement Age, there is no reduction in your benefit, regardless of the amount you earn.

How to Boost My Social Security Benefits

With all of that said, what can you do to maximize the Social Security benefits you’ll receive?

• Work at least 35 years.  As mentioned above, your benefits are calculated based off your highest 35 earning years worked in the Social Security system.  If you worked less than 35 years, those years’ values are zeroed out in your benefits calculation.  So, do your best to make sure you’ve got at least 35 years of work under your belt.  
• Earn as much as you can through Full Retirement Age. In addition to preventing your income being counted as zero for the last years of your career, you can use the income earned more recently to replace smaller values you may have earned at the beginning of your career.  
• Delay benefit distribution.  Every eligible year you delay taking Social Security increases your monthly benefits by about 8% for the rest of your life.  
• Claim Spousal Benefits. This won’t work for everyone, but if you and your spouse were both born before January 2, 1954, and you have both reached Full Retirement Age, you can file a restricted application to claim spousal benefits, leaving yours to keep growing.  Then, when you’re 70 years old, you can switch to your own increased benefits.   And the higher of those benefits is the one the surviving spouse will keep after the first spouse dies.
• Double check the SSA’s work. Make sure that you’re getting credit for the taxes you paid and the income you earned. To do that, you can create a My Social Security account and download your Social Security statement annually.

Mike Hengehold, CPA/PFS MST RICP® Mike is the Founder and President of HCM Wealth Advisors. Over the last 30 years, he’s provided financial planning guidance to a myriad of families to help them realize their financial dreams. Mike is an avid homebrewer and animal lover, and when he’s not at work you can often find him on the golf course working on his short game.