By Eddie Holland, CFP®, CPA/PFS, CKA®
There are many nuances and rules when it comes to Social Security. How do you know your best option? What are some strategies you can use? It can be overwhelming when you really start digging into all the options.
Benefit Types
When we’re talking about Social Security, there are really three types of benefit that you can draw, excluding disability. You can claim on your own record, you can claim off of your spouse’s record, or you can claim on a deceased person’s record, what is called a survivor benefit. Here, we will primarily deal with claiming on your own record.
Full Retirement Age
Social Security defines what a full benefit is based on your year of birth. That’s what most people call the full retirement age (FRA).
Full Retirement Age is based on your year of birth. Anyone born between 1943 and 1954, full retirement age is 66; anyone born 1960 or later, full retirement age is 67. If you’re born 1954 to 1960, the full retirement age goes up by 2 month increments until age 67. You can use the Social Security Administration’s Retirement Age Calculator to confirm your full retirement age.
Why Full Retirement Age Matters
If you claim Social Security prior to your FRA, there’s a reduction in benefit, so there could be a disadvantage to claiming early. If you delay past your full retirement age, you receive a delayed retirement credit, but it’s not always advantageous to wait, either. If you are curious what the reduction or credit may be for you, you can use the Social Security Administration’s Early Late Calculator.
Split Strategy
The split strategy is when one spouse takes his or her benefit early and the other spouse delays as long as possible (until age 70). One option is for the higher wage earner to delay taking the benefit. This may be a good strategy to use if one spouse is still working and there is an unexpected cash need.
Earnings Reduction
It’s important to keep in mind that there is an earnings reduction on top of the early claiming reduction for those claiming Social Security before FRA while continuing to work. The earnings reduction is based on earned income, and the threshold is indexed for inflation.
For example, let’s assume we have a husband and wife. The wife’s full retirement age is 67, and she’s 64 now, claiming Social Security, and working part-time. Her benefit will be reduced if she makes over $19,560, the annual cap based on 2022 figures. Any income she makes over that amount will reduce her benefit $1 for every $2. This reduction is not lost forever but instead is incrementally repaid after she reaches full retirement age. For example, let’s assume that from age 64 to 67, her benefits were reduced $30,000. At full retirement age, she will not get a $30,000 check, but that $30,000 will start to be incrementally repaid to her over a period of time.
Another consideration regarding this strategy is the timing of when someone reaches FRA. If a person reaches full retirement age earlier in the year, it’s probably not going to be as applicable compared to someone who reaches FRA much later in the year.
Let’s look at another example. Let’s assume that you are retiring in October, and you have earned around $50,000 already by that point. You’re younger than full retirement age, and you know you’re over the $19,560 threshold. Social Security allows you a one-time provision to petition them to say, “Ignore my earnings history. Apply the threshold limit on a go forward basis starting when I retire.” They would ignore the 50 grand you’ve made up to this point, and as long as you don’t make more than $1,630 every month going forward ($19,560 threshold divided by 12), then you would get an unreduced benefit from an earnings standpoint, but still subject to the reduction for claiming earlier than full retirement age.
Social Security Taxes
So how are Social Security benefits taxed? Every state has different laws for taxing Social Security, so we will just look at federal taxation.
There is a very detailed formula published by the IRS. However, for our sake, we will look at a general scale based on your combined income: your adjusted gross income plus half of your Social Security benefits.
Once you calculate your combined income, this dollar amount is applied to a graduated scale to determine how much of the Social Security benefits are taxed. If you’re married filing jointly, and your combined income is less than $32,000, none of your Social Security benefits are taxed. If your combined income is in between $32,000 and $44,000, then roughly 50% of your benefits will be taxed at your marginal federal income tax rate. If your combined income is over $44,000, up to 85% of your benefits will be taxed at your marginal federal income tax rate. (Note: this is not an 85% tax rate, it’s the percentage of the benefits that are considered taxable income.)
As you can tell, determining how much of your Social Security benefits are taxable is important when considering income tax planning strategies such as a Roth conversion.
Medicare
There are different types of Medicare that cost different amounts and provide different benefits. Medicare Part A covers “inpatient hospital stays, care in a skilled nursing facility, hospice care, and some home health care” and doesn’t cost anything for most people. Medicare Part B covers “doctors’ services, outpatient care, medical supplies, and preventative services” and is a premium that’s based on your modified adjusted gross income. In 2022, the base Medicare Part B premium is $170.10. If your adjusted gross income is higher than a certain amount (and they look back at your tax return from 2 years prior for this), you will have an Income Related Monthly Adjustment Amount (IRMAA) added to your premium. This is essentially a surtax.
The IRMAA calculation uses a graduated scale; therefore, your premium increases the higher your income is. For example, if you have income of $750,000 or more, you’re going to pay $578.30 per month for Medicare Part B per person (based on 2022 figures). As you can see, there’s a big range of Medicare premiums depending on your income.
So why does that matter? Well, let’s say that someone is retiring at year-end from a high paying job. This person will lose health coverage and must enroll in Medicare. If the person’s salary was $500,000, for example, then they’re going to pay a $544.30 monthly Medicare Part B premium.
There is generally a two-year lookback for this IRMAA calculation. Your Medicare Part B premium is adjusted every year at the beginning of the year. At that time, the most recent tax return on file is from two years ago. So, for example, when we rolled the calendar forward to 2022, the most recent tax return for most people was the 2020 tax year since they haven’t gotten the forms yet to file for 2021. This means you could potentially be in a higher Medicare bracket based on your pre-retirement earnings. There is something called an IRMAA appeal. If you have a qualifying event, you can apply for that appeal, which could help lower the premium you end up paying. The seven qualifying events are: death of a spouse, marriage, divorce or annulment, work reduction, work stoppage, loss of income from income producing property, or loss or reduction of certain kinds of pension income.
Another consideration when completing Roth conversions is what type of impact this could have on your Medicare premiums. You’ll need to figure out if a Roth conversion is going to increase your Medicare premiums for just one year or multiple years and by how much. This strategy also affects other things like your Required Minimum Distribution, so you’ll need to weigh your options carefully.
Conclusion
As you approach retirement age, there are a lot of different components that you have to think through: Social Security, Medicare planning, tax planning. Should I do some Roth conversions? Should I withdraw more from my IRA to pay off my mortgage? Should I continue working the full year or retire mid-year? All of that is intertwined and interconnected, and most people say, “Hey, I don’t want to retire to start a second career trying to manage my money and figure out how all this is going on.” It can be quite complicated. Make sure you are talking to your tax and financial professionals before making any decisions.
Disclaimer: “Ronald Blue Trust and its employees have general knowledge of the Social Security tenets, however, they do not have complete expertise to provide a full discussion of the details of your specific situation. So, for additional information, contact your local Social Security office.” (and don’t be afraid to ask questions or ask for a supervisor if the information isn’t clear or not what you were expecting.) Information is accurate as of date of publication.
15303328-07-22
