When it comes to Social Security, nobody likes surprises. For retirees on modest, fixed incomes, even a small miscalculation can have significant consequences. And even for clients who aren’t dependent upon the program, an unexpectedly small check could make it tough to preserve assets and balance needs with wants amidst inflation, rising health care costs and longer life expectancies.
But according to Nationwide Retirement Institute research, 24 percent of recent retirees report their benefits are less than expected. In fact, future retirees can expect to receive $1,610 per month on average, while recent retirees are only collecting $1,378.
In some cases, beneficiaries receive smaller-than-expected checks simply because they didn’t account for the automatic withholding of taxes and Medicare premiums. Still, garnishments, uninformed collection strategies and poor tax planning can contribute to a significant disruption in seniors’ income plans. To help your clients plan for the long term and avoid a short-term cash crunch, you’ll want to communicate the possible reasons why their checks could be smaller than they expect.
Most seniors understand that the earlier they collect, the lower their benefits, but few fully understand the Social Security Administration’s penalties. Today’s full retirement age (FRA), for Social Security purposes, is 66, collecting at 62 1/2 leads to a lifetime 25 percent penalty, and retiring even one year early reduces the benefit to 93.3 percent of the primary insurance amount.
“It’s almost always more beneficial for a person to wait,” says Ben Barzideh, wealth advisor at Piershale Financial Group. Medicare starts at 65, however – the FRA for the pre-baby boomer generation – and the confusion leads some to start both programs at once.
Another pitfall affecting more and more boomers is that of taking a six-month lump sum after FRA. If someone retires at 70 and takes the lump sum, they’ll receive delayed retirement credits as if they had retired at 69 1/2.
“Part of this is just animal instinct,” says Doug Amis, COO and president of Cardinal Retirement Planning. “It’s not the best option for the highest lifetime benefit, but people like the idea of getting the lump sum now.”
Finally, collecting early while working may create the biggest unexpected deficit of all. In addition to early collection penalties, 2017 workers collecting earlier than the FRA will have $1 deducted for every $2 earned over $16,920. If they reach the FRA in 2017, they’ll have $1 deducted for every $3 past $44,880. Those deducted dollars will be added back into future checks, but clients who don’t understand the deductions ahead of time could see their retirement plans derailed.
Much to beneficiaries’ chagrin, Social Security income is subject to the federal income tax. If a couple has a combined income between $32,000 and $44,000, 50 percent of their benefits may be subject to their regular tax bracket – 85 percent if they earn more. Most lifelong workers are used to having taxes withheld, but they may not understand just how much their benefits will be taxed.
“If someone moves to another state, they might also be surprised to see state tax withholdings,” adds Barzideh.
Thirteen states currently tax Social Security – and while most offer significant deductions, higher-income beneficiaries will have to pay. Minnesota, North Dakota, Vermont and West Virginia have no Social Security exemptions at all.
Seniors can really get in tax trouble, however, when they fail to coordinate collections with retirement account distributions.
“For those years when you’re in a lower tax bracket, the math works better to live off 401(k)s and IRAs and let Social Security build up,” says Barzideh.
Clients who do the opposite may see their already reduced benefits subject to a higher tax bracket once they hit required minimum distributions at 70 1/2.
For most Medicare beneficiaries, Part B premiums are automatically withheld from Social Security. Part D and Advantage customers can opt for the same, although a two-month lag may lead to a particularly small check in the month the deduction kicks in. While beneficiaries do have the option to manually pay Part B premiums quarterly, “There’s absolutely no benefit to doing it yourself,” says Amis. “I would even say there’s a risk, since there’s always a chance you’re going to be on vacation or in the hospital without having sent in your premiums.”
While Medicare withholdings aren’t typically cause for concern, the program’s means testing can result in some unpleasant surprises.
“If a couple makes more than $170,000 per year, they’re going to pay almost twice as much for Parts B and D,” says Amis.
In fact, the 2017 Part B premium goes up to $428.60 – more than three times the base premium – for joint filers over $428,000.
“There’s also a two-year lag effect with the income-related monthly adjustment,” Amis adds.
A retiree’s 2017 Medicare premiums, for instance, are based on his or her 2015 tax return. For recently retired high earners, as well as seniors who sell their homes, this gap can lead to greatly disproportionate premiums.
“Fortunately, this is one thing that can be undone,” says Amis. “You can appeal it with a special form, and the government will refund the surcharge.”
In the meantime, however, clients should be aware of any potential cash flow crises.
Private creditors can’t touch Social Security, but benefits can be garnished for child support, alimony, back taxes and non-tax debt owed to federal agencies.
“I have seen it happen to high earners, but it’s usually related to a change in circumstance – a bankruptcy or major medical bill that causes a cash crunch and ultimately a tax debt,” says Amis.
Unpaid student loans can also trigger garnishment, and there are more people over 65 with student loan debt than ever before. In fact, retiring co-signers could be on the hook if their children default. No more than 15 percent of a recipient’s benefits can be garnished, but that threshold has not been adjusted for cost of living.
The importance of delaying collection
Medicare premiums and tax brackets can be optimized to a degree, but ultimately, delaying collection is the best way for clients to boost their lifetime benefit and overall retirement income.
“It all comes down to planning well in advance,” says Amis. “There are lots of things you can do to avoid surcharges, but it’s very hard to influence 35 years of earnings. Even modern day annuities, which provide lifetime benefits, don’t have the inflation adjustment and degree of growth that Social Security offers.”