In today’s world, retirement doesn’t necessarily mean what it used to—in fact, it has become common for clients to continue to work and earn income in some capacity well into their retirement years. The question then becomes how this earned income impacts the tax treatment of the client who is also currently claiming Social Security benefits. Unsurprisingly, the rules in this area can prove to be tricky—and evolving issues surrounding the concept of full retirement age now add a new level of complexity to the picture. It is up to the advisor to help each client determine how to minimize the impact of any additional taxes that may be applied to his or her Social Security income as a result of continuing to earn income during retirement.
The Social Security Tax Dilemma
Generally, a client can begin to collect Social Security benefits even while he or she continues to work and earn income. However, a portion of that benefit will be subject to tax rules that differ from the otherwise applicable tax rates.
In 2017, if a client a client is younger than full retirement age, collects Social Security early and earns more than $16,920, his or her Social Security benefit will be reduced by $1 for every $2 that he or she earns over that limit. This earnings limit is applied on a calendar year basis (January-December), rather than based on the individual client’s birthday. The limit is also indexed annually for inflation (the amount for 2016 was $15,720).
During the year in which the client reaches full retirement age, the lower $16,920 amount is increased to $44,880 in the months prior to the month in which the client actually reaches full retirement age. Further, during those months, his or her Social Security benefits are only reduced by $1 for every $3 that is earned above the $44,880 limit. For example, if the client reaches full retirement age in September, his or her benefit will be reduced during the months of January through August, assuming his or her earned income exceeds $44,880.
Once the client reaches full retirement age, his or her benefit is no longer reduced regardless of earned income.
It should be noted that these reductions are made in addition to any otherwise applicable income taxes that apply to the client’s Social Security benefit—when an individual earns over $25,000 per year ($32,000 for a married client), one-half of his or her Social Security benefit plus any earned income will be taxable.
Despite all of this, if a client’s Social Security benefit is reduced because he or she continues to work during retirement, the client will actually receive a higher monthly benefit amount once he or she actually reaches full retirement age. Essentially, the system treats such a client as though he or she did not choose to claim benefits as early as he or she actually did claim benefits (because a portion of those benefits was actually withheld).
Changes to Full Retirement Age
Rules enacted to change what constitutes full retirement age add another complication to the picture of when a client’s Social Security benefits will be reduced.
Full retirement age—the age at which the client can claim the full amount of his or her Social Security benefit—has been age 66 for several years (the earliest age at which a client can begin collecting benefits is age 62). However, under rules designed to eventually increase full retirement age, if a client turns age 62 in 2017 (i.e., the client was born in 1955), his or her full retirement age will actually be age 66 and two months.
Eventually, a client who retires in 2022 will not be considered to reach full retirement age until they are age 67. This is important because the general tax rules discussed above only apply to a client until he or she reaches full retirement age (meaning they only apply if the client is claiming a reduced early Social Security benefit).
While the rules governing working during retirement can be complex, they continue to apply more frequently in today’s retirement planning environment—and as the trend of working longer does not appear to be going away, it’s time for advisors to become even more familiar with these rules.