One topic is front and center for most retirement-minded Americans: Social Security. Will it be there in the future? Will benefits be reduced? What changes will Congress make? When should benefits be started?
I want to bring to your attention several aspects of Social Security that you’ve possibly not considered before. Things that could help you get higher lifetime benefits – I want you to get your decisions about Social Security “right”. The “right” decisions on Social Security will help you and your spouse, if you’re married, have a better retirement. First, let’s paint a background for Social Security and retirement.
All the money you paid into the Social Security fund while you were working has been spent by Washington – mostly on foolish things like bridges to no where and wasteful ear-marked pork barrel projects like the mating habits of boll weevils, indigenous to the high plains of west Texas. The money is gone and in its place the Government has given you IOUs – they’re called Treasury Bonds and Notes. Not to worry, there’s light at the end of the tunnel…and it’s not a train.
Will the government redeem their Bonds and Notes so they can continue to pay you Social Security? I think they will because they have options!
First, take more money from workers now paying into Social Security and pay it to you. Does that sound like a Ponzi scheme where there is no pool of money but old investors are paid with money coming from new investors? Well, it is a Ponzi scheme, but unlike other Ponzi schemes it is legal. There’s a slight problem with the Social Security Ponzi: 75 million Baby Boomers born between 1946 and 1964 are now turning 65 at a rate of one every 7.5 seconds, 10,000 a day or 4,000,000 a year and this will continue for the next 18 years. All the boomers want their Social Security benefits. The ratio of workers to retirees is getting smaller and this means taxing workers more will fall short of closing the funding gap. This leads to the second option the government has to redeem the IOUs to pay your SS benefits: taxes are going to rise…not just on workers but on everybody. I know the politicians have told you that won’t happen – but what always happens when politicians tell you something is not going to happen? Correct, it happens.
Politicians are becoming very good at raising taxes without admitting they’re raising taxes – here’s some ways it will happen.
Print more money! What’s happened in the past couple of years? Government expenditures have exceeded government revenues – to the tune of about $1.4 trillion in FY 2010. The shortfall has been financed by borrowing – but that can’t go on forever, so it is inevitable that more money will be printed UNLESS the government cuts expenditures. Fat chance that’s going to happen! So what does printing money have to do with taxes? Cranking up the printing presses creates inflation – which means everything costs more and if you’re living on a fixed income, like retirees do, your money will not buy as much. So inflation is a “silent tax” but the end result is the same: you have less and the government has more. If Washington just raised taxes you’d vote them out of office – so inflation is the stealth method they use to trick you. So what else can they do?
They could raise taxes, and no doubt such will happen but in a shadowy way – like under-funding states and cities so they have to raise your taxes and in turn take the blame. Expenditures could be cut, but massive cuts are needed to address the problem. Frankly, Washington doesn’t have the fortitude to make the drastic cuts in expenditures to bring the printing presses to a halt. No doubt some or all of the foregoing will be tried at one or more times in the future, but I suspect the problem will not be totally solved. There are only two remaining solutions.
First, the government could refuse to honor its Social Security and Medicare commitments. You’d vote politicians out of office in a flash and they know it. So default is not going to happen – over 50 million voters now get Social Security benefits and another 75 million boomers are turning Social Security age and will also vote to keep their benefits. Default or doing away with Social Security benefits will not happen.
The only remaining option, in addition to raising taxes, cutting expenditures and printing more money is to start whittling away the benefits for current and future Social Security recipients. The retirement age could be raised for future retirees! The annual cost of living adjustments could be lowered or eliminated! Spousal benefits, which are discussed below, could be scaled back! The “wealthy” could be denied benefits! A loophole was closed which permitted previous benefits to be repaid without interest so the recipient could qualify for higher benefits going forward. The reason cited was expense reduction. You’ll pay more taxes on your Social Security benefits – this is a certainty as we’ll see in a moment! So what can you do to protect yourself? Plenty – let’s see what’s available.
Did you know that Social Security benefits grow by 8% annually, plus a yearly cost of living adjustment, if you’re postponing benefits beyond age 62? Age 62 is the first year you can start taking benefits and you never want to delay beyond age 70 because that is when the 8% growth stops. Also, did you know that a surviving spouse gets what the deceased spouse was getting if it is greater? In other words, postponing Social Security as long as possible up to age 70 is probably the best investment you can make! Where else can you get: 8% annual growth guaranteed, not all of the income is taxed (as we’ll see shortly), a government promise that payments will be made, an annual raise for inflation and out of this world spousal benefits?
What could go wrong if you postpone? You might die – when dead you’ll not worry about not getting your Social Security and your surviving spouse will be thankful for the higher benefits resulting from your postponement. The fact is, for a couple aged 62 or more there is almost a certainty that your lifetime benefits will be greater if you postpone as long as you can. If Las Vegas were giving the same odds you’d be there with your retirement money on the table. Postponing Social Security is the smart move if:
1. You can afford retirement without Social Security.
2. You have qualified money – IRA, 401k, 403b, etc.—you can use first.
3. You are the primary breadwinner and have a younger spouse.
4. The non-breadwinning spouse is in good health.
5. You want to save taxes – I’ll explain in a moment
Even though postponing Social Security until age 70 is smart, over 70% of the current SS recipients started before normal retirement age. Why? Mostly because they did not know about the 8% growth and the annual adjustment for inflation, they didn’t know about the super spousal benefits, they were afraid that the government would default on making SS payments, they didn’t know you could save taxes by postponing SS and using qualified money first, or they got bad advice from their broker who said “take it early and invest it in the market so you’ll have more later” – of course, those that followed that advice have generally had less later, not more.
How do taxes work on Social Security? It’s complicated, so bear with me. You first have to measure your Provisional Income – sometimes called Combined Income. This is a special measure of income that includes 50% of your SS benefits and most other income you receive including income from tax-free municipal bonds. Regardless of your Provisional Income, never more than 85% of your Social Security benefits are subject to federal income taxes. That’s why I said earlier that SS is tax-advantaged! Currently, a maximum of 85% of your SS benefits are taxable if your Provisional income exceeds $32,000 and you are single, or if married and filing jointly the level is $44,000. The tax is only on the amount that exceeds these threshold levels. How do you feel about paying taxes on Social Security? Would you like to reduce the taxes? There is a way, I’ll explain in a moment.
Previously I mentioned that if Congress does nothing, eventually everyone will pay taxes on their Social Security. The reason is because these threshold levels – the $32,000 for single and $44,000 for couples – is not indexed to inflation. So, in future years as inflation raises SS benefits above the threshold limits – remember Social Security benefits are adjusted annually for inflation – everyone’s benefits will exceed the thresholds and be taxed. That’s the sneaky way Congress used to make sure everyone eventually pays taxes on Social Security. So the question is: how can paying taxes on Social Security be eliminated or lowered? There are at least three ways you can do this:
- You can postpone taking Social Security and first use your fully-taxable money – IRA, 403b, 457, 401k or other employer pension plan money.
- You can put your interest earning money in tax-deferred annuities whose earnings are not counted until you actually withdraw it. Currently tax deferred income is not counted in computing the Provisional income.
- You can convert IRA money to Roth IRA, pay the taxes now and use the money converted and earnings thereon tax-free later in retirement. Currently, Roth IRA income is not counted in Provisional Income.
By postponing SS benefits, you’ll get more later which means more of your retirement money will be tax-advantaged. You’ll keep more of your money and pay the government less. In other words, by using fully taxable money first while SS is growing at 8% annually, relatively more of your retirement money will be in SS benefits which have lower taxes. So you don’t think this is a small number, research shows that for a married couple when the primary breadwinner postpones SS, their lifetime benefits will be about $200,000 more. That is a meaningful amount of money and it’s yours if you postpone SS and use your fully taxable money first. The brokerage industry argues that the foregoing is incorrect because you could start early, invest the SS benefits and you’d have more later! Sounds logical but does it ring true? Let me dispel the logic by asking you a question: where can you earn 8% annually, get an adjustment for inflation, use on a tax-advantaged basis and get a government promise the money will be paid? I know of no place you can get these sterling benefits other than “postponing SS”.
If you’re married and both are at normal retirement age you can have your cake and eat it too. Here’s how…let’s say John and Mary, a married couple, are each age 66 and both are eligible for SS benefits. Mary is the stronger gender and is expected to outlive John by at least 5 or 6 years – if you don’t think ladies are the stronger gender, visit a nursing home and you’ll see the proof. Here’s John and Mary’s plan: Mary will start her SS benefits immediately, but John will postpone his benefits and become Mary’s dependent. As her dependent, John will get 50% of what Mary gets – and when he reaches age 70 he’ll file for benefits based on his work record. John’s benefits will be about 40% more than Mary’s because he postponed. Since John is expected to pass on several years before Mary, she can look forward to a higher income as John’s surviving spouse. Yes, she’ll miss John, but at least she’ll have the peace of mind of a better income.
How can you lower taxes? Simple! Let’s say you have $250,000 in a bank CD and it is earning you $10,000 a year – dream on, but maybe in a few years it will. This $10,000 is not only fully taxable but also included in your Provision Income calculation – remember this measure of income is what determines the taxes on your SS benefits. Let’s say you’ll not need this $250,000 until several years later – if at all. So you move it from the bank to a fixed annuity issued by an insurance company. You earn the same $10,000 annually, only now it is tax-deferred –meaning you do not have to claim it as income on your tax return. Also, it is not counted in the Provisional Income calculation. Presto, you just lowered your taxes – more for you and less for the government.
Would you like to make future earnings on your qualified money tax-free and also not have to count it as income, or include in Provisional Income, when used? If you think income taxes are headed higher – and I do – or you think you’ll be in a higher income tax bracket when you use your money, then converting totally or partially to a Roth IRA could be a wise move. You pay the income taxes during the year you convert and thereafter all earnings are tax free. What’s more, you can pass it forward to your loved ones as your legacy and they get to use it tax free during their lifetime. Current tax rates are fixed until tax year 2013, unless Congress changes, and then the smart money is betting they will rise markedly to address the huge federal deficits that is adding $1.3 trillion annually to the $14 trillion national debt. You can systematically convert to a Roth IRA over several years to manage your marginal tax bracket, and many astute retirees are doing exactly that because they predict that taxes are headed higher. I would advise you to work with a professional if converting IRA money to a Roth because there are certain limitations that need to be taken into consideration.
There are lots of little tricks like the foregoing in my book, The Guide to Social Security: Higher Lifetime Benefits and Lower Lifetime Taxes. For the full story about SS I recommend you read the book, but if you’re not the reading type, I suggest you get with your financial advisor and work out the best Social Security strategy for you and your loved one. Chances are you can save taxes, get higher lifetime benefits from Social Security, leave a larger income for your surviving spouse to use and enjoy a better retirement.
It is easy to get Social Security wrong because it is complicated, you generally get no advice or bad advice – even from the good folks at the SS office—and everyone wants to start early because they think benefits are going to stop. Yes, Social Security and Medicare will remain legal Ponzi schemes operated by the federal government, but there is no feasible way to stop the charade. Right now over 70% of retirees got it wrong and it will cost them dearly in retirement – don’t join them, get SS right.
My SS book is available free on the website www.theretirementpros.com if you have an interest. Comments and suggestions are welcome. Read it, talk to your financial advisor and get SS right – you’ll have more money and a better retirement as a result.
Shelby J. Smith, Ph.D.
January 2011
