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Social Security is a benefit nearly 1/5th of the country is currently receiving and the majority of working Americans pay into it. How is something that affects such a large percentage of the population so easily misunderstood and complex? The goal of this article is to deliver the fundamentals of Social Security and develop a much stronger communication with your advisor around the topic. With all that being said, let’s jump right in.

What is Social Security?

In the midst of the worst economic downturn in modern times, the great depression, President Roosevelt signed the Social Security Act in 1935 that would forever change retirement. Social Security, known as the Old-Age, Survivors, and Disability Insurance (OASDI), is a federal program designed to provide partial income replacement to qualified adults, their spouses, qualifying ex-spouses, those who are disabled, and under special circumstances, children.

Social Security encompasses multiple social insurances and social welfare programs, for the purposes of this article, I am going to focus on the issuance of Social Security benefits.

Who Funds Social Security?

So, who is funding Social Security? Well, you, the worker (unless you have a covered pension and are exempt from paying into Social Security). Social Security is a pay-as-you-go system, and the payments are made through a payroll tax. The payroll taxes are known as the Federal Insurance Contributions Act or “FICA”. FICA taxes are a tax of 7.65%, comprised of a 6.2% tax for Social Security funding and another 1.45% to fund Medicare. Of course, your employer must also match your contribution, and if you are self-employed, you must pay FICA taxes both as the employee and the employer (so go ahead and double up that 7.65% if you are running your own business).

In fact, about 90% of the current funding of Social Security is made through payroll taxes. The other 10% is made through a combination of things: taxation of Social Security benefits being paid out to retirees, and interest earned from the current Social Security trust fund (where all the extra money accrued from payroll taxes exceeding payable benefits are stored).

How Does One Qualify for Social Security?

To fit the “fully insured” definition of Social Security, an individual must obtain 40 credits throughout their working lifetime. An individual can earn up to four credits in one calendar year. To earn a credit, the individual must have met the earnings threshold ($1,510 for 2022). These thresholds are updated annually for inflation.

Do they Ever Stop the Taxing?!?!?

Yes, the Social Security tax ends on your wages once you have hit $147,000 in earnings for the year 2022 and this number is adjusted annually with inflation. On the flip-side of this coin, because Social Security taxation caps wages for the payroll tax, they also have a cap on the maximum monthly payment one individual can receive.

Now that we understand the fundamentals of Social Security benefits, let’s look into how your benefit is calculated and all of the fun with claiming a benefit.

How is the Benefit Calculated?

The Social Security Administration actively tracks your income (as well as indexes it) and the years you have paid into the program. Social Security then uses the 35-highest paid years of your working career to determine your average indexed monthly earnings or “AIME”. From your AIME, Social Security arrives at your Primary Insurance Amount or “PIA”. The primary insurance amount is the monthly amount that an individual can claim at their full retirement age. If you are curious what your full retirement age is, enjoy this not-so-complex graphic:

Reductions and Increases to the Benefit

Let’s look at a fictional character for this example, his name is Garfield. Garfield has had an excellent career as an electrician and was born in 1960. Garfield is now 62 and wants to begin planning his retirement. He downloads his Social Security statement and Social Security states his primary insurance from his highest indexed 35 years of earnings at age 67 is $2,000 a month.

What Happens when Garfield Claims Early?

Garfield can claim as early as age 62. Claiming Social Security early will permanently reduce the monthly primary insurance amount “PIA”. Garfield will receive a reduction in the following amounts: For every month he takes Social Security early within 36 months of FRA, his benefit will be reduced by .56% up to a maximum of 20%. For every additional month beyond 36 months, the benefit is reduced by .42% for up to 24 months for a maximum of 10%. The maximum reduced benefit will leave him with 70% of his PIA at age 62.

What Happens when Garfield Delays his Benefit?

Delaying Social Security after FRA will add an additional 8% annually to Garfield’s benefit. If Garfield, with an FRA of 67, delayed receiving Social Security until age 70, he would receive a benefit of 124% of his PIA.

Garfield’s Social Security Amounts would look like this:

Claiming Early Vs. Delaying

Garfield has a tough decision in front of him regarding his Social Security, he likes the idea of claiming later for an increased benefit, but is worried that no male in his family has lived past the age of 76, and he could be leaving money on the table… (and that is why claiming Social Security needs to be decided and based upon each individuals’ financial goals, family health history, and retirement planning.)

Garfield decided to pull the trigger on claiming benefits as early as he could at age 62 and take the reduced payout of $1,400. If Garfield would have waited until his full retirement age, 67, to claim the benefit, his breakeven point would be age 77! At that point, claiming at age 67 becomes a better strategy than claiming at age 62. If Garfield defied the odds on his family’s health history and lived until age 95, that would be a dollar amount of $222,729 that he would be giving up throughout his retirement years by claiming early at age 62.

Working while Collecting Social Security

Early retirees may have their benefits cut if they exceed the earned income threshold ($19,560 for 2022). The benefit will be reduced by $1 for every $2 above the threshold before an individual reaches FRA. For the year in which FRA is obtained, the benefit will be reduced by $1 for every $3 above the threshold ($51,960 for 2022). There are no earned income limits once FRA is obtained.

Garfield was such a great electrician during his career, and like a lot of retirees these days, he decided to optionally work part-time to keep himself in motion. He started his own electrician business and did 5-10 house calls a week, Garfield was able to make $30,000 in his first year of retirement doing house calls, while only working 2 days a week (the rest he spent fly fishing). Because Garfield is below the FRA, the benefit will be reduced by $1 for every $2 above the threshold of $19,560. Garfield will have his annual Social Security benefit reduced from $16,800 to $11,580 for the year because he did not know of this earned income limit☹.

Who Can Claim the Benefit?

This is a common question we see as financial planners, while it can get overly complex, the typical claims to one’s benefits we see are the spouse (can claim 50% of the benefit at their FRA), an ex-spouse who was married to the fully insured participant for at least 10 years, and a surviving spouse who gets 100% of the benefit at FRA. If you do like getting into the weeds, here is a complex chart to go ahead and look through.

Taxation of Social Security

This is another topic that can get complex very quickly. I will stay short and sweet on this one, in 2021 if you filed single, the benefits are not taxable below an income of $25,000. Up to 50% of the benefits are taxed between $25,000 and $32,000 and up to 85% of the benefit is taxed with income above $32,000. If married filing joint, the benefits are not taxed with income below $32,000. Up to 50% of the benefit is taxed when income is between $32,000 and $44,00 and up to 85% of the benefit is taxed above $44,000. Here is the formula that determines how much your Social Security is taxable: ½ of Social Security Benefits + Adjusted Gross Income + Nontaxable Interest = Combined Income. Meet with your tax professional to discuss missing any Social Security “bump zones”, when extra income in retirement makes more of your Social Security taxable.

Does Social Security Receive a Cost-of-Living (COLA) Adjustment?

Yes! This is why Social Security is often referred to as the best annuity option in the world. I won’t go into detail on this, but I have already written an article if you are interested in reading through how the COLA works.

Believe it or not, a lot of what this article discusses only scratches the surface of how complex Social Security can get in certain scenarios. It is important to understand the fundamentals of claiming Social Security and how it will impact your retirement income. Here at Whitaker-Myers, we are proud to have the heart of a teacher and continue to educate on this topic to our beloved clients. Social Security is something that should be reviewed and analyzed with your financial planning team prior to implementation. Please review with your financial professional/professional tax advisor.


September 30, 2022

Dustin Burkhart

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