Stop Retiring Early, People!

 

When I was 30, I set a goal of being able to retire at age 50. I’m still on track for that goal, but with my 44th birthday coming up next month, I now wonder what the hell was I thinking. I don’t want to retire. I get bored on a three-day weekend. I need to have mental activity, variety, and the sense of purpose and fulfillment that comes with work. So, no, I won’t be retiring at 50 even if I can.

Social Security: It Pays to Wait

Social Security is a cornerstone of retirement planning. Although financial planners spend considerable time thinking about portfolio construction and sustainable withdrawal strategies, nothing beats Social Security in terms of its lifetime guaranteed income and automatic inflation adjustments. Given the significance of Social Security in retirement, it’s remarkable how many people don’t do any numerical analysis about when to start benefits. There is a strong behavioral bias to start benefits early. In fact, 74% of beneficiaries begin benefits before their Full Retirement Age (66 for those born between 1943 and 1954).

2016 Contribution Limits and Medicare Information

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Inflation was almost non-existent in 2015 due to falling commodity prices. This means that for 2016, most of the IRS contribution limits to retirement accounts are unchanged. Zero inflation creates some unique problems for Social Security and Medicare beneficiaries, which we will explain.

If you are automatically contributing the maximum to your retirement plan, good for you! You need not make any changes for 2016. If your contributions are less than the amounts below, consider increasing your deposits in the new year.

2016 Contribution Limits
Roth and/or Traditional IRA: $5,500 ($6,500 if age 50 or over)
401(k), 403(b), 457: $18,000 ($24,000 if age 50 or over)
SIMPLE IRA: $12,500 ($15,500 if age 50 or over)
SEP IRA: 25% of eligible compensation, up to $53,000
Gift tax annual exclusion: $14,000 per person

Tax brackets and income phaseouts increase slightly for 2016, but there are no material changes. People are still getting used to the new Medicare surtaxes, which include a 3.8% tax on net investment income (unearned income), and a 0.9% tax on wages (earned income). The surtax is applied on income above $200,000 (single), or $250,000 (married filing jointly).

Capital gains tax remains at 15%, with two exceptions. Taxpayers in the 10% and 15% tax brackets pay 0% capital gains, and taxpayers in the 39.6% bracket pay a higher capital gains rate of 20%. For 2016, you will be in the 0% capital gains rate if your taxable income is below $37,650 (single) or $75,330 (married).

For Social Security recipients, the Cost of Living Adjustment (COLA) for 2016 is 0%. We previously had a 0% COLA in 2010 and 2011, and it creates an interesting situation for Medicare participants. Medicare Part A is offered free to beneficiaries over age 65. Medicare Part B requires a monthly premium.

Part B premiums should be going up in 2016, but about 75% of Part B participants will see no change, thanks to Social Security’s “Hold Harmless” provisions. The “Hold Harmless” rule stipulates that if Medicare Part B costs increase faster than Social Security COLAs, beneficiaries will not have their SS benefits decline from the previous year. And since there is no COLA for 2016, any Medicare Part B premium increase would cause SS benefits to negative.

For the past three years, Part B premiums have remained at $104.90 per month. You are eligible for no increase under the “Hold Harmless” rule, if you are having your Part B payments deducted from your Social Security benefit AND you are not subject to increased Medicare premiums under the Income Related Monthly Adjustment Amount (IRMAA).

For most Part B recipients, Medicare premiums are fixed. For higher income participants, IRMAA increases your premium, as follows for 2016:

MAGI $85,000 (single), $170,000 (married): $170.50
MAGI $107,000 (single), $214,000 (married): $243.60
MAGI $160,000 (single), $320,000 (married): $316.70
MAGI $214,000 (single), $428,000 (married): $389.80

If you fall into one of these income categories, above $85,000 (single) or $170,000 (married), you are ineligible for the “Hold Harmless” rule and will have to pay the premiums above, even if this causes your Social Security benefit to decline from 2015.

If you are delaying your Social Security benefits and pay your Part B premiums directly, you are also ineligible for the “Hold Harmless” rule. Finally, if you did not participate in Social Security, for example, teachers in Texas, you would also not be eligible for the “Hold Harmless” rule.

What Should You Expect from Social Security?

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The big surprise this week was that the new budget approved by Congress and signed by President Obama on Monday abolishes two popular Social Security strategies for married couples. The two strategies that are going away are:

1) File and Suspend. A spouse could file his or her application but immediately suspend receiving any benefits. This would enable the other spouse to be eligible for a spousal benefit, while the first spouse could continue to delay benefits to receive deferred retirement credits until age 70.

2) Restricted Application. Also called the “claim now, claim more later” strategy, this would allow a spouse to restrict their application to just their spousal benefit at age 66, while continuing to defer and grow their own benefit until age 70.

Both of these strategies were ways for married couples to access a smaller spousal benefit, while still deferring their primary benefits until age 70 for maximum growth. And now, these strategies will be gone in 6 months from today. It was estimated that these strategies could provide as much as $50,000 in additional benefits for married couples. Needless to say, people close to retirement who were planning on implementing these strategies feel disappointed and upset.

Some Baby Boomers have done a lousy job of saving for retirement and are going to be heavily reliant on Social Security. According to Fidelity Investments, the average 401(k) balance as of June 30 was $91,100 and their average IRA balance is $96,300. If an investor had both an average IRA and 401(k), they’d still have only $187,400. But those figures don’t tell the true depth of the problem facing our nation, because those “average balances” don’t count the 34% of all employees who have zero saved for retirement. For many retirees, savings or investments are not going to be a significant source of retirement income.

Looking at current beneficiaries, the Social Security Administration notes that 53% of married couples and 74% of single individuals receive at least 50% of their income from Social Security. For 47% of single beneficiaries, Social Security is at least 90% of their retirement income! As of June 2015, the average monthly benefit is only $1,335, so that should give you some idea of how little income many retirees have today.

Our country simply cannot afford to let Social Security fail, and yet the current approach is unsustainable. People think that Social Security is a pension or savings program, but it is not. It is an entitlement program where current taxes go to current beneficiaries. Back in the years when the ratio of contributors to retirees was 5 to 1, there was a surplus of taxes which was saved in the Social Security Trust Fund. Currently, there are only 2.8 workers per beneficiary and since 2010 Social Security benefits paid out have exceeded annual revenue into the program. By 2035, there will be only 2.1 workers per beneficiary, and this demographic change is the primary reason the system cannot work in its current form.

Today’s estimate is that the Trust Fund will be depleted by 2034. The Disability Trust Fund will be depleted next year, in 2016, at which time funds will have to shifted within Social Security to pay for Disability benefits not covered by payroll taxes.

The 2015 Trustees Report calculates that to fix Social Security for the next 75 years, the actuarial deficit is 2.68% of taxable payroll. This represents an unfunded obligation with a present value of $10.7 Trillion. Every year, the Trustee’s Report tells Congress the size of the shortfall, so Congress can take steps to either reduce benefits or raise taxes to correct the problem.

Unfortunately, changing Social Security has become a “hot potato” which no politician wants to touch. For those who have been brave enough to propose a solution, they are attacked with one-liner sound bites, accusing them of “trying to take away your Social Security benefits.” It is so disappointing that our elected officials cannot come together on a solution to ensure the solvency of our primary source of national retirement income.

It was surprising that the two Social Security claiming strategies were abolished so quickly and with such little opposition or discussion. This will save Social Security a small amount, but it’s doubtful this will make any material improvement in the program’s long-term viability.

For workers close to retirement, it seems unlikely that there will be any significant changes to the Social Security system as we know it today. The best thing you can do is to delay benefits from age 62 to age 70, which will result in a 76% increase in benefits. If you live a long time (to your late 80’s or longer), you will end up receiving greater lifetime benefits for having waited, and the guaranteed income from Social Security will decrease the “longevity risk” that you will deplete your portfolio over time.

For younger workers, I think it is highly probable that we will see the Full Retirement Age increase or a change in how the Cost of Living Adjustments are calculated. For high earners, I believe that you will see the current income cap of $118,500 increase significantly or be removed altogether. Another proposal is to apply a Social Security tax to unearned income, such as dividends and capital gains, to prevent business owners from shifting income away from wages in order to avoid taxes.

I think the strongest approach for investors will be to save aggressively so that your nest egg can be the primary source of your retirement income. Then you can consider any Social Security benefits as a bonus.

A Business Owner’s Guide to Social Security

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For many small business owners I meet, their business is their retirement plan. They expect that either they will be able to receive an income while handing off day-to-day management to an employee or they hope to sell the business and use the proceeds to fund their retirement. Both approaches carry a high degree of risk as the success of one business will make or break their retirement. As a financial planner, I want to help business owners achieve financial independence autonomous from their business.

Social Security plays a part in their retirement planning, but for most people covers only a portion of their expenses. While the Social Security Administration observes that 65% of participants receive more than half of their income from Social Security, the average Social Security benefit today is only $1294 a month and $648 for a spouse.

Five Social Security Considerations for Business Owners

For the sake of simplifying the points below, I am assuming that the business owner is the husband, but anyplace I use “he”, this could of course be “she”. Age 66 is the Full Retirement Age (FRA) for individuals born between 1943-1954, however, the FRA increases from 66 to 67 for individual born between 1955 and 1960.

1) Salary versus Distributions

While sole proprietorships generally pay self-employment tax on all earnings, business owners who have established as an entity such as a corporation or LLC may receive income from salary as well as distributions or dividends. Only salary is countable towards your Social Security benefit; other forms of entity income, such as distributions or dividends are not subject to Social Security taxes and therefore not used in determining your Social Security benefit amount. (Benefits are calculated based on your highest 35 years of income, inflation adjusted; the Social Security maximum wage base for 2014 was $117,000.)

Avoiding Social Security taxes (15.3%) is often a consideration in selecting an entity structure. For example, we may see an owner pay himself $50,000 in salary and take another $100,000 in distributions from the company profits, rather than taking all $150,000 as salary. At retirement, a business owner’s Social Security benefit amount is only based on their salary, so in the example above, his benefit amount will be less than a worker who received the full $150,000 as salary. I’m not suggesting that business owners should forgo these tax savings and take more income as salary, however, they should consult with their financial planner to estimate their Social Security benefits and create other vehicles to save and invest their tax savings to make up for the lower SS benefits they will receive as a result of taking a lower salary.

2) SS between 62 and FRA

Approximately half of SS participants start taking benefits immediately at age 62; 74% of current recipients are receiving a reduced benefit from starting before FRA. Starting at age 62 will cause a 25% reduction in benefits versus starting at age 66. While SSA will automatically recalculate your benefits if you continue to work while receiving benefits, the actuarial reduction (up to 25%) remains in place for life.

3) Survivor Benefits

Many people consider their own life expectancy in deciding when to start Social Security. The payback for deferring SS benefits from age 66 to 70 may take until age 79 or 80, depending on your estimate of COLAs. If the owner is concerned that they will not live past 79 or 80, they often take benefits at 66. However, there is an additional vital consideration which is survivorship benefits for your spouse.

A surviving spouse will receive the higher of their own benefit or the deceased spouse’s benefit. The higher earner’s benefit will end up being the benefit for both lives. Therefore, it often makes sense to maximize the higher earner’s benefit amount by delaying to age 70, especially if the spouse is younger and has a longer life expectancy. For each year you wait past age 66, you receive an 8% increase in benefits (delayed retirement credits or DRCs), which is a good return. When people take early benefits based solely on their own life expectancy, they fail to consider that their benefit also impacts their survivor’s benefit amount.

4) File and Suspend

One of the problems with delaying to age 70 is that the owner’s spouse will be unable to receive a spousal benefit until the owner files for his benefit. This is generally not an issue if the spouse has a substantial benefit based on her own earnings. If she does not, however, there is a solution to enable the spouse to receive her spousal benefit while the husband delays until age 70. In a “File and Suspend” strategy, the business owner files for benefits at age 66, to allow his spouse to receive her spousal benefit, (the full amount, provided she is also age 66 or higher). The owner then immediately suspends his benefit, which entitles him to earn the deferred retirement credits until age 70.

DRCs do not apply to the spousal benefit, so if the spousal benefit applies (spousal is higher than her own benefit, or she does not have a benefit based upon her own work record), she should not delay past age 66. That’s why it is essential to know if a spouse will receive their own benefit or a spousal benefit. The spouse should never delay past age 66 if receiving a spousal benefit – you’re losing years of benefits with no increase in amount.

To recap: File and Suspend works best when the spouse is the same age or older and has little or no earnings history on her own.

5) Claim Now, Claim More Later

For a business owner who is still working, but whose spouse has already filed for her own SS benefit, at his FRA, he can restrict his application to his spousal benefit and receive just a spousal benefit. This will allow him to still receive DRCs and delay his own benefits until age 70, while receiving a spousal benefit without penalty. That’s free money. (Note: this only works when spouse is already receiving benefits and he is at FRA. You cannot restrict an application to the spousal benefit prior to FRA.)

I can help you to compare different Social Security timing strategies to make the best decision for your situation. Before we get started, you will need to first download the current Social Security statements online at www.ssa.gov/myaccount/ for both yourself and your spouse. A Social Security statement never shows any spousal benefit amounts, and the calculators on the SSA website do not consider file and suspend strategies, so you cannot consider these scenarios without using other tools.

How to Maximize Your Social Security

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When should I start my Social Security benefits? I am asked this question frequently and find that many otherwise rational individuals don’t actually look at any data or analysis when making this important decision. As a financial planner, I have the tools to help you take a closer look at all your options to make an informed choice, rather than relying on heuristic biases. The first step, though, is to understand what happens when you start at age 62, 66, or 70. And that’s what today’s post aims to accomplish.

74% of Americans start their Social Security benefits early, before the Full Retirement Age (FRA) of 66 (for individuals born between 1943-1954). Starting at age 62 will result in a reduction in benefits to 75% of your primary insurance amount (PIA). If you wait past age 66, you will receive Delayed Retirement Credits (DRCs), equal to 8% a year, or a 32% increase for individuals who wait until age 70. Many of the individuals who wait until age 70 do so because they are still working. However, even for individuals who retire at age 62, it may make sense to delay benefits to age 66 or 70 and live off other sources of income, in order to receive a higher future Social Security benefit.

Delaying from age 62 to 70 offers a 76% increase in benefits. For example, someone with a PIA of $1000 a month would receive this amount at age 66, but would receive $750 at 62 or $1320 at 70. While COLAs or additional earnings will increase your benefits regardless of when you start, a 2% COLA is obviously going to produce a higher dollar increase if your benefit amount is $1320 rather than $750. So in nominal dollars, the difference between 62 and 70 typically exceeds 76%.

For single individuals, the decision is relatively straightforward. Social Security was designed so that a person with average life expectancy will receive the same benefits regardless of whether they start at age 62, 66, or 70. On an individual level, if your life expectancy is above average, you will receive greater total lifetime payments by delaying benefits until age 70. And if your life expectancy is below average, you will not have enough years of higher benefits to make up for the lost years, so you should start benefits earlier. The breakeven for delaying from age 66 to age 70 is between age 83 and 84. Delaying from 62 to 70 creates a breakeven between age 80 and 81.

Since 74% of recipients start benefits early, the behavioral bias is that people are underestimating their life expectancy. It should be 50% – half of us will live shorter than average and half will live longer. Unfortunately, many of the 74% will live longer than average and their choice means they will receive lower lifetime benefits than if they had delayed to age 66 or 70.

In addition to life expectancy, the other consideration for a single individual is if they have other sources of income. If he or she can get by with withdrawals of 4% or less from their portfolio from age 62 or 66 to age 70, then I would encourage them to delay the Social Security benefits.

Delaying benefits will reduce the future withdrawals required from their portfolio and increase the likelihood that their portfolio will be able to provide lifetime income. When I run Monte Carlo analyses for clients, those who fund a larger percentage of their needs from guaranteed payments like Social Security (or a Pension) have a greater probability of success than retirees who are more dependent on portfolio withdrawals. A larger Social Security benefit reduces the impact from poor potential outcomes in the stock and bond markets, or from an initial drop in the market, called Sequence of Returns Risk.

For married couples, the decision to delay benefits becomes more complex. Neither your Social Security statements nor the calculators on the SSA.gov website help with coordinating spousal benefits. Often, it may make sense to delay for one spouse but not for the other.

A general rule for couples is that you should consider maximizing the higher earning spouse’s SS benefit amount by delaying to age 70. The larger benefit will become the survivor’s benefit, so in effect, the higher earner can consider his or her benefit to be a joint and survivor benefit. And if the spouse is younger or has a high life expectancy, than delaying to age 70 for the higher earner may be an even better idea, in terms of actuarial odds.

Social Security is a good hedge for portfolio performance and an 8% guaranteed increase for delaying one year is a valuable benefit. I looked at quotes this month for immediate single-life annuities and for a 66-yr old male versus a 67-yr old, the rate increase was only 2.2%. Delaying from 66 to age 70 increased the annuity benefit by 12.2%. That gives you an idea of how exceptionally valuable the 8% annual increase is (or 32% for waiting four years), given the low interest rate environment we face today.

Aside from the principle of delaying the higher earning spouse, it is difficult to make other generalizations about delaying to age 70 as the details of a couple’s specific situation typically determine the best course of action. I use financial planning software to analyze your options and suggest an approach to coordinate your benefits into your overall financial plan. There are two tools which married couples might consider to provide some often-missed benefits as one or both defer to age 70.

The first tool is the ability to file and suspend. At full retirement age (66), you can file for benefits but immediately suspend the payments. This enables your spouse to be eligible to receive a spousal benefit, while you can continue to receive deferred credits for delaying to age 70. This is typically used if the spouse does not have any SS benefit based on their own earnings, or if the spouse’s individual benefit is less than the spousal benefit amount (half of the first spouse’s PIA, if the second spouse is at FRA).

If a spousal benefit applies, it is important to know that DRCs are not added to a spousal benefit. While the primary spouse will receive the 8% increase after age 66, the spousal benefit does not increase. So, if the spouse is the same age or older than the higher earning spouse, it is important to not delay the spousal benefit once both are age 66.

The second tool is a restricted application. At FRA, a spouse may restrict their application to receive only their spousal benefit amount and still earn Deferred Retirement Credits on their own benefit. Then they can switch to their own benefit at age 70. However, to receive any spousal benefit, the other spouse must be currently receiving benefits. This works if you want to delay from age 66 to 70 and if your spouse is already receiving benefits (or has filed and suspended).

These two tools provide a benefit from age 66-70 which many people miss. Both techniques will allow one spouse to defer their individual benefit to age 70 to maximize their payment amount (and potentially, the survivor’s benefit amount), while receiving an additional benefit for those four years. If you might benefit from either of those tools, don’t expect the Social Security Administration to tell you. And if you miss those benefits, you’ll lose free money that you can’t get later.