Investors who are about to become retirees, or retirees who haven't filed for social security, often wonder about the implications of working after they start filing for social security. There are a few concepts that need to be specifically identified to avoid confusion.
Taxes on Social Security Benefits
The first thing to identify is "taxes". A tax is not the same as a benefit being withheld, though investors may feel like the two events are just different names.
Merrill Edge has an excellent graphic on the way taxes on social security benefits work:
The key to take away from this is the idea of provisional income and what levels trigger each portion of social security income to be classified as "taxable". The nice thing about this is that the "provisional income" figure uses "adjusted gross income" as one part of the calculation. That means there may be opportunities for meaningful deductions. Given the extremely precise brackets and the dramatic change in how much of social security income will be taxable, it would be wise to get some tax planning help if you are near the cut-offs.
Whenever possible, a retiree would be wise to reduce the impact of these taxes. Since the formula includes things like "tax-exempt income", it gives retirees a substantial incentive to restructure their income. Sadly, one of the ways to do that is to shift to an investment strategy that emphasizes capital gains rather than dividends. The investor can choose when to sell the investments and reap the capital gains (if asset prices cooperate), which can assist in planning when income occurs. There is no benefit for being stuck with these taxes.
Benefits Withheld Due to Earnings
The other concept for retirees to know about is the premise that benefits are withheld when a retiree claims early and then continues to have earned income. The reduction in benefits can be pretty severe. For someone with a few years left until they reach "full retirement age", the limit on earned income is a mere $15,720. Clearly, $15,720 is nowhere near enough to support an adult with a normal lifestyle. For those that are extremely savvy about pinching every penny, it may be quite possible if there is a small home that is paid off, in an area with very low property taxes.
The reduction in benefits on income over this amount would come to $1 per $2 of income exceeding the threshold. However, the term "income" here refers to categories that are generally thought of as wages. It does not refer to the "provisional income" used for taxes. The Social Security Administration explains it as follows (bold emphasis is theirs):
"When we figure out how much to deduct from your benefits, we count only the wages you make from your job or your net profit if you're self-employed. We include bonuses, commissions and vacation pay. We don't count pensions, annuities, investment income, interest, veterans or other government or military retirement benefits."
Benefits Withheld Isn't Too Bad
The idea of an effective 50% tax rate sounds terrifying, but that isn't the case. The Social Security Administration designed the system so that when the retiree hits the "full retirement age", their benefits are recalculated. That provides two opportunities for benefits to increase. The first is if the last few years involved a high enough income level to replace previous years in the work history. That would improve the base figures the social security administration uses in determining your "full benefit".
If a retiree is drawing social security early, they will be receiving less than the full benefit, but an increase in the full benefit would still be nice.
The other way it can increase income is because the Social Security Administration will withhold entire checks rather than creating a fractional reduction in each check. When the retiree hits full retirement age, their "starting age" for drawing benefits is recalculated as if they had waited for however many months they missed their benefits. For instance, if they had 12 payments withheld, the new calculations could raise their "starting age" from 62 to 63. That would increase the portion of the "full benefit" that would be paid to the retiree in each subsequent month.
Theoretically, if the "retiree" continued to work and earn so much that the entire benefit was withheld for every month, the result would be a recalculation that determined the retiree was not "starting" until they reached the full retirement age. In this case, there would be no difference between filing at 62 and filing at the full retirement age, because the retiree would not receive a single cent from social security, and the recalculation would (or should) correctly reflect that.
Retirees shouldn't be so afraid of having benefits withheld due to earnings, unless they expect to die in the near future. If they expect a long retirement, then benefits that are withheld are simply treated as a delay in the retirement age. For retirees that expect to live to an old age, that is a very sound investment.
The taxes on social security benefits don't offer a great benefit down the road. It is simply an opportunity to pay more in taxes. This is where the larger efforts of financial planning should be applied for most investors. Use of municipal bonds can be significantly weakened as an investment strategy, since tax-free income is used to determine if other income should still be tax-free. If an investor is coming in materially below the lowest cut-off, they should consider selling assets that would generate capital gains to move them closer to the cut-off. If it appears they will be just over the cut-off, they may want to look at securities in an "unrealized loss" position that could be sold to generate a capital loss.
As always, nothing should be construed as financial advice or tax advice. If you need guidance, seek a professional that knows your unique situation.
If you're not sure about the benefits of filing at any given age, check out my research on "When Should You File For Social Security Benefits?".
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