How to plan and save for retirement, whether to use traditional IRAs or Roth IRAs, when to retire, how and when to draw down funds from IRAs, when to take Social Security [SS] benefits are all daunting subjects that require either significant research and thought by the individual or the services of a trusted and knowledgeable professional. I've written a few articles on the importance of retirement planning and on the need to start planning early. You can find those articles here on Seeking Alpha. Today, I'm of the opinion that there is not a single answer to most of these retirement planning questions that will work for everyone or even most people. An individual's or family's circumstances, retirement needs, and resources during their working years should be considered in planning for retirement and deciding when to do what. This article attempts to shine a brighter light on one aspect of retirement planning, that being, what are the pros, cons, and considerations associated with taking SS benefits before full retirement age (early) or waiting until 70 (late)?
For those folks that participate in the SS program (the vast majority of the US population), there are several options for when and how to take SS benefits. We have the option of taking benefits starting at age 62 (earliest), at full retirement age (65 to 67), between 62 and full retirement age or waiting beyond full retirement age to take benefits at 70. Spouses can take benefits based on their individual earnings or a spousal benefit based on spouses' earnings. Taking benefits early does come with a monetary monthly penalty of up to 30% for those enrolling in benefits at 62 versus their full retirement age of 67. The Social Security Administration has done a pretty good job of explaining the transition from the previous full retirement age of 65 to the new (everyone born in 1960 or later) full retirement age of 67. It should be noted that the spousal benefit penalty for taking benefits early at 62 is an even larger 35%. If we wait till after our full retirement age to take benefits, there is a bonus of roughly 7.5% per year additional benefit up to the age of 70. So, how do we make this decision? What are the pros, cons, and impacts we should consider in making this decision?
If you are considering taking a lower benefit earlier than at full retirement age, one of the things you would probably like to know is how many years it will take before the higher benefit at full retirement age would be greater in terms of total benefits collected. This is generally referred to as a "break-even analysis". For example, if one's full retirement benefit would be $3,033 per month ($36,400 per year) at age 67 (born 1960 or later), but you are considering taking the 70% benefit of $2,125 per month ($25,500 per year) available at age 62, at what age would you break even? Likewise, if one chose to wait until the maximum age (70) to start taking benefits and get a monthly benefit of $3,770 ($45,200 per year), at what age would you break even on the total collected payments.
There are a few ways to do this type of analysis. For this article, I chose to use Excel so that I could produce some charts to show the break-even concept visually. The chart below shows the break-even results under the assumption of the SS payments being spent, deposited into a no interest checking account, or stuffed into a mattress. In other words, no investment returns on SS payments.
The chart above shows that if you were to take SS benefits at age 62 versus at your full retirement age of 67, you would be ahead of the game until about the age of roughly 78.8 years. In other words, it would take 16.8 years before you would "break-even". If you believe you will still be kicking after the age of 78.8 years, it would be financially beneficial to wait and take your SS benefits at the full retirement age of 67, provided you can afford to wait on receiving benefits. The green line shows your cumulative SS payments if you waited until the age of 70 to start receiving benefits. Interestingly, if you take benefits starting at age 70, your break-even age compared to taking benefits at 67 moves out to 82.4 years. Waiting until age 70 to take benefits means you need to still be around at 82.4 years of age to break even. So, what if you could take those SS payments and invest them? How would that work out?
It is possible to push out the age at which you break even if you can invest all or a portion of the early SS benefit payments. The chart below shows the break-even analysis under the assumption of investing the paid benefits at a real return of 2%.
The chart above shows that the break-even age for taking benefits at 62 years compared to 67 will move out to about 81.1 years old assuming a 2% real return. If you wait until 70 years old to start taking benefits versus at 67, your break-even age will move out to 84.9. Astute readers might be wondering why anyone would take benefits at 62 and invest the payments to push out the break-even age when you can get a guaranteed 7.5% increase per year in your SS benefit by simply delaying benefits until 67 or later. The answer is a rather morbid thought but allows you to hedge your bet on how long you will live. We all would like to live to 100 years or more but we also know that most of us will not reach that age. We might not make it to the age of 78 let alone into our 80s. To be able to take benefits at age 62, invest the benefit payments, and push out the break-even age to 81 or 85 is a way to hedge your bet on longevity. If you don't make it to 81, at least your spouse or heirs will benefit from the additional benefits paid early and invested.
As you would expect, the break-even age for both early and late options compared to taking SS benefits at 67 continues to move to the right. In other words, you have to live longer to get to the break-even age.
This type of analysis can be done to evaluate the break-even age for the case where an individual is considering a delay in taking benefits until after full retirement age. It took me about 30 minutes to put together the break-even Excel spreadsheet that produces the graphs above but if you prefer to use a web-based calculator, I did find a couple on the Google search page linked here.
Some readers are probably thinking that a 4% real return is fairly conservative and a 2% real return is exceptionally conservative. Based on the average return for the S&P 500 over the last 100 years, I would agree. However, I have always invested retirement assets using a conservative approach. The types of investments I'd consider for squirreling away excess SS benefit payments would be mutual funds like the Vanguard Wellington Fund (VWENX), exchange-traded funds [ETF] like the iShares U.S. Preferred Stock ETF (PFF), and the Vanguard Utilities Fund (VPU). I've found that getting that 4% real return every year for 15 to 20 years is no small challenge. Since the beginning of recorded time, my personal retirement portfolio real return is 4.1% on an average annual return basis. Okay, maybe not since the beginning of recorded time but the last 38 years.
There are a few other potential pros and cons to take into consideration before making the decision to take SS benefits early versus at full retirement age (or later). Most of these additional considerations are not so concrete and quantifiable as the break-even analysis above and some fall out of the future health and sustainability of the SS program.
SS Program Funding - By now, everyone should know that the SS Program is projected to have a shortage of funding around 2035. Many readers will recall the past political discussions when Congress adjusted the full retirement age from 65 to 67. Excess SS taxes would be placed into a "Trust Fund" to pay future benefits for retirees. In truth, there was no trust fund and the excess SS tax payments have gone into the Treasury like any other tax receipt and have been spent. In truth, the trust fund is nothing more than a financial accounting arrangement where the US Treasury provided interest-bearing Special Obligation Bonds for the tax receipts owed to the Social Security Program for future benefit payments. Since about 2010, SS tax receipts have been insufficient to cover benefit payments and the SS Program has been relying on the interest from the Special Obligation Bonds to cover the shortfall in tax receipts. Starting in about 2021, the interest payments will be insufficient to cover the shortfall and the SS Program will have to start redeeming the Special Obligation Bonds in order to pay current SS benefits to retirees. This means that the US Treasury will have to start paying back the previously spent excess tax receipts. In or around 2035, the Special Obligation Bonds will all be redeemed and the SS Program will not be able to cover all of the then current benefit payments due to retirees. The most credible estimates indicate roughly a 30% shortfall in SS tax receipts versus benefit payments in 2035. This is the driver for Congress debating over what to do to fix the SS Program for future retirees.
None of the potential "fixes" for the SS Program is easy or painless. As I see it, the list of potential fixes is as follows.
My opinion, which is free and probably worth no more, is that the first 4 bullets above have some potential to be included in a legislative fix for the SS Program. The last two I believe to be fairly low probability. While there is no way to accurately predict what changes will be made, it is clear there will have to be some changes to the SS Program for it to be viable long term. As Congress dawdles on a fix, the changes required to fix the system grow in magnitude and complexity. The fact that there will be changes might be another reason to enroll in SS Benefits early rather than late.
Money Now Versus Money Later - It is often the case that early retirees spend as much and sometimes more in their early retirement years than they did while working. With more free time, retirees have the ability to travel, take up new pursuits, and generally have fun. Having fun costs money. It is also generally true that in their later years of retirement, retirees slow down and spend less. If you are an early retiree, you might want to enroll in SS benefits early to have access to additional funds in order to pay for travel, new pursuits, and other forms of fun while you are young and energetic.
Interplay Between SS Benefits and Qualified Retirement Plan Withdrawals - One of the more complicated issues to figure out is the income tax ramifications from various retirement income streams. Roth IRA distributions are not taxed and do not count towards the income threshold for taxation of SS benefits. So, if you only have Roth IRA(s), you can probably skip this section.
Traditional IRA distributions are not only taxable as ordinary income, they also raise your modified adjusted gross income that determines whether and how much tax you will pay on your SS benefits. In your annual income tax calculation, you will add one-half of your SS benefits for the year to your other taxable income. If that total is above $25,000 for single filers or $32,000 for joint filers, you will owe some income tax on a portion of your social security benefits. If you decide to begin taking distributions from your qualified plans in lieu of SS benefits, thus delaying SS benefits, you may be able to lower your overall income taxes in retirement. On the other hand, if you delay taking qualified plan distributions AND SS benefits, you could be in for some hefty tax bills in your later years. It should be noted that this is a very cursory discussion about taxation of retirement benefits. The purpose of this discussion is only to highlight that taxes are another factor in deciding when you enroll for SS benefits.
The majority of articles available on the internet and in financial publications recommend or support waiting to take SS benefits until at least full retirement age. Many recommend waiting until age 70 to maximize your monthly benefit payment. From a purely financial analysis, the longer you wait to take SS benefits, the more you will collect in total provided you live beyond the point of break-even. While I'm not recommending any particular course of action with this article, I believe it is important to consider all the pros and cons before you make the decision on when to enroll for benefits versus making the decision based solely on collecting the maximum benefit under the assumption that you will live long enough to collect them.
Disclaimer: This article is intended to provide my opinion to interested readers and to serve as a vehicle to generate informed discussion in the comment posting. I have no knowledge of individual investor circumstances, goals, portfolio concentration or diversification. Readers are strongly encouraged to complete their own due diligence on any stock, bond, fund or other investment mentioned in this article before investing.
This article was written by
Disclosure: I am/we are long VWENX, PFF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.