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Retirement Planning > Social Security

Early Retirement: Building A Bridge To Social Security

By Tom Fridrich

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These days, many people dream of an early retirement. Sometimes, early retirement is planned and, sometimes, it’s not. Some workers are enticed by an early retirement incentive from their employer; while others are forced into the situation by a layoff or disability.

For whatever the reason, advisors are seeing more and more clients who retire from their job before reaching the normal Social Security retirement age. Many of these retirees choose to receive their Social Security benefit early even though it means a reduced monthly income.

Social Security reduces benefits by 1/180 for each month an individual retires before the normal Social Security retirement age. For example, if someone with a Social Security retirement age of 67 retires and begins receiving Social Security payments at age 62 (60 months early), his or her monthly Social Security benefit is reduced by 33%–significant reduction in retirement income. Depending on what other retirement assets a person may have available, the situation can adversely affect one’s lifestyle during retirement.

Bridging The Gap

You may want to suggest to some of your clients who find themselves in the early retirement scenario to find another source of income to meet their needs until they reach normal Social Security retirement age. An immediate annuity can serve as a way to accomplish this in a simple and efficient way because you can design it to begin paying when your client retires and end when the Social Security benefits commence. Knowing that their Social Security payments will continue for life, your clients can retire when they choose–without the risk of running out of money later in life.

For example, suppose your client retires early from his full-time job at age 61, even though his normal retirement age for purposes of Social Security is 66. He decides to work part-time in a position outside of his original profession. Instead of taking Social Security benefits early and receiving reduced benefits for the rest of his life, you suggest your client consider an immediate annuity to fill the income gap until his normal retirement age.

Together, you determine after his part-time employment income, he needs an additional $20,000 annually before taxes to sustain his lifestyle for the next five years. He is in a 25% tax bracket. If he uses non-qualified funds to purchase the immediate annuity, he will benefit from the exclusion ratio and, therefore, will not need to generate the full $20,000. The exclusion ratio allows your client to exclude the amount of the annuity payment that represents a return of principal from his taxable income.

In this case, if your client purchases an immediate annuity for $75,000, he can generate an annual income of $15,972 for the next 5 years. The exclusion ratio for his annuity is 93%. This means 93% of the payments he receives will not be subject to income tax. Since the $15,972 is roughly equal to $20,000 before taxes, the annuity income will meet his needs for the next 5 years–without permanently reducing his Social Security payments–and in a tax-efficient manner.

Another factor to consider in a situation where an individual will receive Social Security benefits early and continue employment is the possibility of having too much earned income. While receiving Social Security benefits before normal Social Security retirement age, for every $2 over $12,960 (for 2007) that an individual earns, his or her Social Security benefit is reduced by $1. Additionally, if provisional income becomes too great, Social Security benefits may also be subject to income taxes. Once you consider all of these factors, you can see that choosing to take Social Security benefits early can often be a poor decision for early retirees.

Delaying Social Security benefits

Most people are aware that Social Security reduces benefits if taken early. However, not everyone is as familiar with the fact that benefits can increase when you delay them beyond the normal Social Security retirement age. For each year an individual delays retirement beyond the normal retirement age, he or she receives a Delayed Retirement Credit, ranging from 6%-8%. Additionally, Social Security adds a cost-of-living adjustment (COLA) to the benefit. Individuals can see an estimate of their Social Security benefits at age 62, full retirement age and at age 70 on the Social Security Statement sent to them annually by the Social Security Administration.

For example, someone born in 1940, who postpones collecting Social Security beyond normal retirement age, receives a Delayed Retirement Credit of 7% annually. In 2006, the COLA for Social Security benefits was 4.1%. Therefore, in 2006, the annual increase for an individual born in 1940 with delayed benefits was 11.1%. Any future increases in the Social Security benefit will be based on the higher Social Security benefit.

Continuing with the same example used previously, if your 61-year-old client chooses to delay Social Security benefits until age 69, he will need an income stream that lasts for 8 years. As mentioned above, his income need before tax was $20,000. In order to provide an income stream for those 8 years, he will need to purchase an immediate annuity for $110,000. The immediate annuity will provide the income to allow him to delay Social Security benefits and ensure a larger lifetime benefit amount. Additionally, by delaying his Social Security payments, his benefit will increase 8% each year beyond his normal retirement age (age 66).

You should consult carefully with your clients to determine if delaying Social Security benefits makes sense for them. There is no Delayed Retirement Credit after age 69. Many advisors and clients believe that it is best to begin receiving benefits as early as possible to ensure your client actually receives the payments. If your client dies earlier than expected, he or she may never receive Social Security benefits or may receive very little of it.

Help your clients who are able to plan ahead for early retirement give careful thought to their income needs. With the right plan in place, you can help them avoid permanently reducing their Social Security benefits. And, for that, they’ll thank you. If there are other assets available, an income annuity can provide the liquidity and security of a financial bridge from early retirement to normal retirement age.

Tom Fridrich, JD, CLU, ChFC, is an advanced markets specialist focusing on retirement planning and charitable giving at Mutual of Omaha. He can be reached via email at .

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