Innovative strategies to help maximize Social Security benefits

Innovative strategies to help maximize
Social Security benefits

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Table of Contents
The five costliest mistakes retirees make about Social Security............................................................................................. 2

What you haven’t heard before about the taxation of Social Security benefits .................................................................. 6

How to bridge the income gap until higher Social Security benefits can begin ................................................................. 11

About the authors ..................................................................................................................................................................... 13

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by James Mahaney and Peter Carlson
For years, financial services companies have downplayed the role of Social
“ Security in bolstering financial security in retirement. But considering the
increased financial risks retirees now shoulder, the tax preferences that Social
Security receives, and the income options that Social Security now offers, we
would argue that Social Security should play an even greater role in a retiree’s
financial picture than it ever has before.”
What’s the greatest fear of today’s retirees? Running out of This information has been provided for your benefit and
money in retirement. And what’s the greatest benefit Social
is not intended or designed to be tax advice. Neither
Security can offer? Regular income that is guaranteed to
Prudential Financial nor any of its associates can provide
increase over time—and continue for as long as you live.*
legal or tax advice for which you should contact your
No other vehicle can match the combination of inflation-
independent legal or tax advisor.
fighting increases, longevity protection, investment risk
Maximizing Social Security benefits is more critical than
elimination, and spousal coverage that Social Security
ever—now that the majority of post-retirement risk has
can—potentially making it one of the most valuable
shifted from the employer to the individual. This results
sources of retirement income.
from the move away from traditional Defined Benefit
Yet many retirees today do not understand how their
(DB) pensions to Defined Contribution (DC) plans such as
Social Security benefits really work. Sadder still, most
401(k)s and even the shift to such hybrid plans as Cash
never focus on how to help maximize the very benefits
Balance plans.
that may help sustain them throughout retirement.
In this paper, we will strive to outline why Social Security
Nor have they been advised how to do so. Given that most deserves to be considered a valuable resource worthy of
financial service firms have been so focused on acquiring
careful stewardship—and how today’s seniors can best
rollover dollars, they have placed little emphasis to date
maximize its benefits while helping minimize the taxes on
on helping retirees learn how they can best use Social
their retirement income in general.
Security to help generate optimal retirement income and
risk protection. If guidance is provided at all, it is often
likely done with misinformation or at least incomplete
information, as this paper will show.
* Social Security taxes are just that—taxes, and convey no property or contractual rights to Social Security benefits. As a result, a worker’s retirement security is entirely
dependent on the political decisions of the President and Congress. Benefits may be reduced or even eliminated at any time.
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The five costliest mistakes retirees make
about Social Security
While some retirees are simply uninformed, others are dangerously misinformed by the “conventional
wisdom” surrounding Social Security. Unfortunately, these misconceptions prevent individuals from
taking the steps that are wel within their control to help maximize this important benefit. Here are five
of the most costly mistakes we feel seniors make about their Social Security benefits.
1Mistake #1: Underestimating the real value
of Social Security
Example
For years, financial service providers have warned us
that Social Security will never provide enough income
A 65-year-old worker with $80,000 of final wages
during retirement. During the “accumulation stage” of
and a non-working spouse can expect approximately
our financial lives, this may have been a wise message for us
$30,000 of initial Social Security income.
to heed. But at the point of retirement, Social Security
should be anything but ignored.
As the income guarantees provided by private employer
Some never take charge of this benefit because they
pension plans disappear, Social Security guarantees
discount the viability of the system in general. But
become even more critical to individuals likely to spend
whatever your personal beliefs are about the Social
25 to 30 years in retirement. According to the Economic
Security reform debate or a “pay-as-you-go system,”
Policy Institute, on average, Social Security provides four
most new retirees have been paying into the SocialSecurity
times more income than private pensions for a median
system for many more years than they have contributed to
income household headed by someone age 56 to 64.1
their Defined Contribution plan. They can count on both
as critical sources of their retirement income.
In fact, the value of Social Security continues to grow
along with wages in particular and the economy in
No serious reform proposal has been offered that
general. A recent paper disclosed that between 1989
would reduce Social Security benefits for those at or
and 1998, the mean real Social Security wealth for those
near retirement.
individuals age 59–61 increased by 43%.2 Better still, these
Although Social Security is not guaranteed by law, it is
benefits are adjusted for inflation each year.
backed by the promise of the U.S. government. Politically,
So rather than ignoring this retirement resource, we
it is difficult to imagine how the government would ever
should embrace it. For many retirees, Social Security
cut benefits for current retirees and throw millions of
will become the centerpiece of retirement income.
seniors into poverty.
They need to understand how best to take their Social
Plus, the promise of Social Security income for a retiree
Security benefits and how their decisions will affect them
is much more certain than the potential for an IRA to
throughout retirement—which will often last one-third
eliminate investment risk, protect against inflation, or
of their lives.
generate lifetime income. Furthermore, with the demise
of Defined Benefit plans, Social Security may be the
only guaranteed lifetime income many seniors will have
available to them.
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2Mistake #2: Rushing to collect, then regretting the Mistake #3: Not understanding how one spouse’s
reduced benefits for the rest of your life
decisions affect the other one’s benefits
Most retirees apply for Social Security benefits early.
For married couples, how and when one spouse decides
In fact, according to the Social Security Administration,
to take Social Security benefits affects the other spouse’s
72% of current recipients receive reduced benefits
lifetime benefits as well.
because they started their benefits prior to their Full
Retirement Age.
3Impact on spousal benefits
Undoubtedly, many of these seniors didn’t realize that
In general, spouses are eligible to receive the higher of:
when they collect affects how much they receive over the
course of their lifetimes. And most certainly didn’t stop to
1) Their own Social Security worker’s benefit; or
think that they could potentially double their
2) One-half of their spouse’s benefit (known as a
initial payments if they only waited until age 70.
spousal benefit).
In fact, most financial planners still recommend taking
Social Security money “early” so that the retiree can
Let’s look at a case where the husband earned more than
invest it, where they can earn much more than Social
the wife during his lifetime—and is eligible for more than
Security could provide down the road. Perhaps this
double her benefits. If he starts collecting Social Security
was true back in the go-go market of the 90s. But
prior to his Full Retirement Age, not only will he be
most economic experts expect future equity returns to
reducing his benefits, he will likely be reducing his wife’s
continue to be low and future yields on fixed-income
lifetime income payments as well.
investments to remain very low.
In the past, if a worker delayed collecting Social Security,
The discussion on when to take Social Security benefits
the spouse would not be able to collect spousal benefits
tends to focus on the “break-even” age; that age when
and would not be receiving Delayed Retirement Credits
you could receive more income from starting Social
either. This reduced the value of delaying Social Security
Security benefits earlier versus starting them later. Some
for many couples.
calculators will also factor in the time value of money
since retirees receiving “early” Social Security benefits
Fortunately, changes made under the Senior Citizens’
could theoretically invest this income for use later
Freedom to Work Act of 2000 allow a worker to “File
in retirement. But these assumptions often ignore
and Suspend” Social Security benefits once the Full
key considerations:
Retirement Age has been reached. This allows the spouse
to begin receiving spousal benefits based on the worker’s
• The value of Social Security Cost-Of-Living-Adjustments
record while the worker continues to accrue Delayed
(COLAs), which, although not guaranteed by law, are a
Retirement Credits.
promise made by the government that would be difficult
to cancel;
• The tax preferences awarded to Social Security income
Impact on spousal benefits
compared to IRA income;
Delaying Social Security can also increase the protection
• The potential interaction between spousal benefits and the
to a surviving spouse. Upon the death of a worker, the
ability to integrate each spouse’s benefits to provide optimal
spouse will receive the greater of:
income and protection;
1) His/her own benefit, including any
• The widow’s benefit, which can be passed on to a spouse
Cost-Of-Living-Adjustments (COLAs); or
at death;
2) The deceased spouse’s benefit, including
• The ability of Social Security to provide income for the rest of
any COLAs.
your life; particularly important since no one can accurately
predict how long that will be.
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In essence, the value of delaying Social Security “lives on”
Mistake #4: Getting blindsided by the “Tax Torpedo”
as the higher benefit (which has grown even higher due
Think of all the contributions that have been made to
to COLAs) is passed on at death to a spouse.
401(k)s and other types of Defined Contribution plans
This is a wonderful way to protect a spouse from running
over the years. Now add all the employer’s matches
out of money. The transition from Defined Benefit plans
on those contributions…and all the earnings on those
to Defined Contribution plans will make more spouses
matches and those contributions. All that tax-deferred
vulnerable to the risk of running out of money later in
4money is just sitting there, much of it likely to be rolled
life, as the mandated offering of a qualified joint and
over to an IRA. But all of it eventually to be withdrawn—
survivor annuity often disappears. The larger Social
and taxed.
Security income benefit could help offset potential
Not only will these withdrawals be subject to tax, but
healthcare costs, nursing home costs, and everyday
they will also generate higher incomes—and therefore
expenses. It also protects surviving spouses from inflation
trigger higher taxation of Social Security benefits.
(since they’ll receive annual COLAs). Plus, it costs them
nothing more for this additional benefit. Better still,
Put it all together, and you’ll see that we’re facing what
it is taxed at a lower rate than other ordinary income.
some journalists have called the “Tax Torpedo.”4
It’s difficult to reproduce this security for a loved one
Individuals for the most part are “okay” with the
through other financial vehicles.
taxation they face on their IRA withdrawals as this was
But many retirees appear to focus only on the initial
part of the “deal” in contributing to a 401(k). They
Social Security benefit amount and not the “second
bought the argument of financial service providers that
stage” of benefit calculation.
they would most likely be in a lower tax bracket when
they retired, so tax deferral was a good deal.
When this second stage calculation is taken into account,
married couples may often find that it’s beneficial for
Yet the tax situation is often worse for the retiree than
the spouse who is eligible for the lower Social Security
expected. Once a very low income threshold is met
payments to start collecting his/her own worker benefits
($34,000 for singles and $44,000 for married couples),
early—while delaying the other spouse’s benefits.
every dollar received from an IRA causes up to 85% of a
Social Security dollar to become taxed also. This creates
Then, at the death of the primary breadwinner, the
a marginal tax of 46.25% in 2006—an amount that will
lower-benefit spouse will “step up” to a much higher
likely increase in the future under current law.
benefit than he/she would then be currently receiving.
Ironically, even though the Tax Torpedo hits seniors
In essence, when the primary worker delays benefits, at
very hard, no one has really looked closely to avoid it.
the death of the first spouse, the smaller benefit drops
Fortunately, it can be avoided—as we’ll discuss in the
off and the larger delayed benefit continues.
next two sections of this paper.
A recent Center for Retirement Research brief emphasizes
Of course, it’s also likely tax rates will increase. Given
this point.3 It suggests that, when considering whether
that cuts into Social Security, Medicare, and Medicaid are
to delay Social Security, not only should the worker’s
politically challenging to make, politicians may resort to
expected longevity be considered, but perhaps more
raising taxes to overcome our projected federal budget
importantly, the spouse’s as well.
deficits. For one, Employee Benefit Research Institute
president Dallas Salisbury believes, “I am absolutely,
personally convinced that income tax rates are going to
go through the ceiling over the next 10 to 20 years.”5
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Example: How delaying Social Security
If both start collecting
If she collects at 62,

can benefit a surviving spouse
benefits at age 62,
he delays benefits to 70,

then he dies at 82
then he dies at 82

Initial benefit for husband
$12,000
$26,172
Initial benefit for wife (on her own work record)
$12,000
$12,000
Benefit that will continue for surviving spouse
$20,700
$36,444
So if the husband dies before his wife (but after he’s begun collecting benefits), she will “step up” to the higher $36,444 (plus future
COLAs from that point forward). The “snowball” lives on and will be able to keep many widows and widowers out of poverty and in a
secure retirement.
Note: The above example is hypothetical and for illustrative purposes only and assumes death of the husband in 20 years, at age 82.
COLAs are projected using Social Security Administration projections as of January 2006.
5Mistake #5: Assuming that more control equates to Yet the inability to delay “ownership” of their Social
more income
Security benefits may cost many retirees dearly. Some
retirees will run out of money before they run out of
Here’s more “conventional wisdom” that unwisely
breath. Others will horde their assets and not enjoy
prevents seniors from maximizing Social Security. Many
retirement to the level that they could have if they had
believe that it’s always better to maintain control over
pooled their post-retirement risks with others.
their money. Thus, they rush out to start collecting Social
Security so they can control how it’s invested. Some
advisors recommend that, even if you don’t need your
Social Security benefits to live on, it’s better to take them
as soon as you’re eligible and invest them on your own.
Why leave it to the government to
“ provide increasing benefits? You can
do it yourself better than Uncle Sam…
”
…the argument goes.
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What you haven’t heard before about the
taxation of Social Security benefits
Put aside what you think you know about how Social Security is taxed. We don’t believe the fol owing
information about the taxation of Social Security benefits has been previously presented. Even if it has
been discussed publicly, it is not widely understood.
Upon closer analysis of the Combined Income formula
(aka Provisional Income formula), you can see that Social
Here’s the key thing to remember:
Security only goes into the formula at a 50% rate. All IRA
Social Security income is not taxed the same as IRA
income and even tax-free municipal-bond income counts
income. So you can reduce your taxes by choosing higher
at 100%.
Social Security income and lower IRA income when you
So wouldn’t it make sense that a retiree could take
develop your strategy for taking retirement income.
at least twice the amount of his/her income in Social
Security rather than in IRA income?
Comparing how IRA and Social Security income are taxed
Yes. Actually, a double benefit often occurs for those
Remember that a retiree has choices on how and when
retirees who would otherwise face the taxation of their
to take IRA income and Social Security income. If you
IRA and Social Security income. Again, think of trading
choose to take IRA income first while delaying the start
IRA income for higher Social Security income. Once
of Social Security benefits, you’re choosing to take higher
you reach age 70 and start taking a much higher Social
lifetime Social Security and lower IRA income. Many
Security amount, you are taking one additional dollar
individuals who take IRA withdrawals will trigger the
in the form of Social Security income as opposed to
taxation of their Social Security benefits that they have
IRA income.
already received. In fact, every one additional dollar of
Better still, you do not pay tax on that Social Security
IRA income often causes 85 cents of a Social Security
dollar “out of the box,” which is not true of the IRA
dollar also to become taxable. A 46.25% marginal tax
dollar. Instead it goes into the Combined Income formula
rate applies to that one additional dollar of income if the
at a 50% rate. So, whereas a 25% tax rate applies, the
retiree is in the 25% tax bracket: ($1 + [$1 x .85]) x .25.
retiree with IRA income (and lower Social Security) is
Note that a first threshold exists ($25,000 for singles and
paying taxes as follows compared to a retiree who,
$32,000 for married couples filing jointly) where up to
instead of receiving that dollar in the form of IRA
50% of Social Security benefits are taxed.
income, receives it in the form of Social Security.
To our knowledge, all experts make the “false leap”
that the tax on Social Security can’t be avoided, and
therefore assume that 85% of all Social Security will be
taxed as ordinary income once singles and couples hit
the retirement income thresholds of $34,000 and $44,000
respectively. However, this is not true!
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How combined IRA income and
How every dollar of “delayed”
Social Security income is taxed:
Social Security income is taxed:


IRA income

$1
Social Security Income

$1
Tax rate
x
25%
Combined income formula
x
50%
IRA tax (A)
=
.25



=
.50
Additional Social Security subject to tax
$1
% of Social Security income
% of Social Security income
subject to taxes
x
85%
subject to taxes
x
85%
Taxable Social Security income
=
.85
Taxable Social Security income
=
.425
Tax rate
x
25%
Tax rate
x
25%
Social Security tax (B)
=
.2125
Social Security tax
=
.1062
Total tax in cents (A + B):
=
.4625
Total tax in cents:
=
.1062
Total tax in percentage:
OR
46.25%
Total tax in percentage:
OR
10.62%
What is the Combined Income formula, and how does it work?
The Combined Income formula (also known as the Provisional Income formula) determines how much of a retiree’s
Social Security benefits are subject to taxation. Up to the thresholds listed below, Social Security benefits are tax-free.
Once the first threshold is reached, up to 50% of Social Security benefits are subject to taxation. Once the second
threshold is reached, up to 85% of Social Security benefits will be taxed. Listed below are the current first and
second threshold limits, respectively.

Single person:
$25,000 and $34,000

Married couple filing jointly:
$32,000 and $44,000
Modified Adjusted Gross Income (MAGI) plus interest from tax-exempt bonds* plus 50% of Social Security benefits
is compared against these thresholds. Note that it is “up to” either 50% or 85% of Social Security benefits that are
taxed. See page 8 for how the tax is actually calculated.
* There are additional amounts that must be included in MAGI. Please consult your tax advisor for details.
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Why this isn’t just a tax benefit at the lower
Why extending tax deferral isn’t always the best route
income levels
Conventional wisdom has held that it’s always better
This example even assumes that the higher Social Security
to delay taking income during retirement from a tax-
income is taxed at the full 85% of benefits. But in reality,
deferred product (such as an IRA) for as long as possible.
the Combined Income formula calculates the tax on the
But this frequently does not hold true as the tax benefits
smallest of:
from much higher Social Security make up for any
1) 85% of the benefits; or
benefits of delaying the receipt of IRA income.
2) 50% of the benefits plus 85% of any excess over the
The example on the next page represents the dramatic
second threshold; or
drop in Adjusted Gross Income in a given year for
3) 50% of the excess over the first threshold, plus
someone who delays Social Security and therefore earns
35% of the excess over the second threshold.
a higher amount after age 70.
Many individuals will therefore pay little to no taxes
The retiree is trading IRA income for higher Social
when they delay Social Security and take higher Social
Security income after age 70.
Security income and lower IRA income. Usually, this
• The retiree under Approach A took the traditional
results from #3 above as the least of the three tests.
route and took Social Security early and is taking
Consider that a married couple could have $64,000
IRA withdrawals.
of Social Security income (counting as $32,000 at the
• Under Approach B, the retiree took Social Security later
Combined Income rate) before they would ever have
and is therefore taking $25,000 more in Social Security this
“excess over the first threshold.”
particular year and $25,000 less in IRA withdrawals.
And although it is not intuitively clear, it is not just
Even though the same $90,000 of pre-tax income is
retirees who are near the income thresholds of $25,000
provided, Approach B has an AGI of $35,625 less than
to $44,000 who will benefit, but individuals who receive
Approach A.
much higher retirement income as well. Our research has
found that many individuals with after-tax income, up
In other words, shifting $25,000 of income to Social
to the mid $90,000 range, can see significant tax savings
Security removed 142% of that amount from the AGI.
from delaying Social Security.
AGI was reduced by half. Many retirees could see a 75%
drop of actual taxes paid when considering both federal
and state taxes. This is the Tax Torpedo in reverse.
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