Social Security and Medicare are the cornerstones of most retirement planning strategies. One provides an income stream that you cannot outlive. The other provides health insurance when you are most likely to need it.
How Your Social Security Payment Is Determined
Social Security takes your highest 35 years of reported income, adjusts them for inflation, adds them up, and divides by 35 to arrive at your average income. Then a sliding scale is used to determine what percentage of that average income you will receive. The higher your average, the less of a percentage Social Security will replace. The standard amount to be replaced is around 42% of your average income.
The year you were born determines the age (full retirement age, or FRA) that you can retire and start receiving your full Social Security. For people born before 1960, it is around age 66 plus some months. For anyone born after that, it is age 67.
Suppose you decide to start receiving your Social Security at the earliest time, age 62. In that case, you will receive somewhere around 70% of your full retirement benefit. (A percentage reduces your retirement benefit for every month that you receive your benefit prior to your FRA.) Anyone who delays receiving their Social Security past their full retirement age sees their payment increase 8% per year until age 70. After age 70, the 8% increases end.
The breakeven point for someone whose FRA is age 66 but takes Social Security at 62 is age 78. After that age, the total payments received would have been larger if they had waited until age 66 to start their payments. People who start taking their benefit when they reach their FRA of 66, instead of waiting until age 70 and getting the additional 8% a year, bump up breakeven to age 82 1/2.
An individual claiming a benefit based on their spouse’s work record must be at least 62 years old. The maximum spousal benefit is 50% of their spouse’s FRA benefit. At age 62, it is 35%. For a citizen to receive Social Security based on their spouse’s work record, the spouse with the work record must also be taking Social Security payments. Many people are usually eligible for a more significant payment based on their employment history. Social Security pays the higher of the two.
Individuals are eligible for a benefit on the worker’s record if they were married to the worker for ten years and have not remarried. However, because many people qualify today on their work history, the 50% maximum spousal/divorced spouse benefit is usually less than the amount that they are eligible for on their record.
One difference for divorced spouses is that the worker does not need to be receiving social security for the divorced spouse to qualify.
Widows and Widowers
Widows and widowers are eligible for their deceased spouse’s benefit. If their spouse started social security early, for example, at age 62, after they pass, the remaining party would qualify for that amount, or 82.5% of their FRA benefit, whichever is more significant. If their spouse waited until age 70 to receive their maximum amount, that amount is compared to their work record to determine which amount they will receive.
Widows and widowers have the option to start receiving a widow’s benefit at age 60, two years earlier than anyone else. They can also take their widow’s payments and let their earned Social Security benefit increase up to age 70.
To receive a widow’s payment, the surviving spouse must be unmarried or must have been married after age 60.
Divorced spouses are also eligible for a payment if they were married for over ten years. They, too, must be unmarried or have gotten married after age 60.
Receiving Social Security While Working
After you reach your FRA, you can make any amount without reducing your Social Security payment. If you are not at your FRA, then you could experience a significant drop in your Social Security payment.
In 2021, you can earn up to $18,960 without a reduction in Social Security. If you earn more than that, then you will have one dollar of Social Security withheld for every two dollars you earn. So, if you make an additional $40,000 for a total of $58,960, then $20,000 of Social Security payments will be withheld.
That money is not lost. Social Security adds back what was withheld to your future payments, paid when you reach your FRA.
There is another rule for the year you retire. If the year you start drawing Social Security is before your FRA, then you can make as much as you want in the months before you get your first payment. In the subsequent months in that year, if you make less than $1,580 a month (less than $18,960 a year), then you can keep all your Social Security for that month. If you make more than that, then you will receive no Social Security in that month.
If you retire in the year when you reach your FRA, then Social Security only uses the months before you reach the FRA. You can make as much as $50,520 a year or $4,210 a month in those months without reducing Social Security. If you make more than that, then the reduction is $1 for every $3. Once you reach the FRA, you can make any amount without any reduction in Social Security.
Taxes on Social Security Payments
Low earners do not pay taxes on their Social Security. High earners do but only on 85% of it. To determine if your Social Security is taxable, you take your gross income and any tax-free income and one-half of your Social Security.
If you are single and your added number is less than $25,000, you owe no taxes on your Social Security. If you are married and filing jointly and make less than $32,000, you owe no Social Security taxes.
* Cambridge doesn’t offer tax advice.
Medicare consists of four components: Parts A, B, C, and D. Remember, you and your spouse will have your own plans. There are no family plans.
Part A covers hospitalization and has no cost to the participant. It pays for hospitalization for 60 days. After that, the participant must pick up part of the price. It has a reasonably good-sized deductible, which someone might end up paying more than once a year.
Part B is medical insurance. It is voluntary. It has a premium based on your income and a copayment of 20%. It covers doctors’ costs, testing, and other medical costs separate from hospitalization.
Part C replaces Parts A and B with a private plan that looks like the kinds of insurance you get from work. You still must pay the Part B premium and a premium to your Part C provider. Some Part C plans provide for prescription drugs.
Part D is the newest component. It pays for medical drugs, is voluntary, and has a premium. However, it does not pay all costs. As you might be aware, it has a famous doughnut-hole structure.
Most people become eligible for Medicare when they reach age 65. If they happen to be on Social Security already, then they are automatically enrolled in Medicare. If not enrolled in Social Security, it is highly recommended that an individual contact Social Security three months before age 65 to discuss their Medicare options.
If not automatically enrolled, an individual has three opportunities to sign up for Medicare. The initial enrollment period is at age 65. The special enrollment period is for individuals over 65 who are still working and who have health insurance from their work or their spouse’s work. They can sign up for Medicare without penalty when their employment or insurance ends. The third enrollment period is the one you want to avoid. It is the general enrollment period. General enrollees incur penalties, and coverage delays apply.
General enrollment penalties include a permanent 10% per year increase in your Part B premiums. The enrollment period is limited to the first three months of the year. Coverage does not begin until July of that year.
There is another type of plan called Medigap or Medicare supplement plans that fill in some of the Medicare gaps, such as the Part A limit on the number of days allowed in a hospital, the 20% copay in Part B, or the fact that Medicare does not pay for foreign care.
These plans are private. However, there is a six-month window starting when someone turns 65 or when someone still working past 65 who has health insurance through their work or their spouse’s work cannot be denied coverage for a preexisting condition or pay a higher premium because of that condition.
Some people might get confused and miss this enrollment period and subject themselves to Medicare’s general enrollment penalties if they have retiree health insurance, which might make them forget to sign up for Medicare Part B at age 65. Remember that the ability to sign up for Part B after age 65 and enroll in a Medigap plan without regard to preexisting conditions happens when you have health insurance from your work or your spouse’s work, not from having retiree health insurance.
Landis, Andy, “Social Security the Inside Story”, An Expert Explains Your Rights and Benefits, CreateSpace Independent Publishing Platform, North Charleston, SC 2016 Edition, https://www.amazon.com/Social-Security-Inside-Story-2016/dp/1523650249, Andy Landis Website http://www.andylandis.biz/
How much can I earn in the year I reach full retirement age without losing Social Security benefits? AARP, Updated December 23, 2020 https://www.aarp.org/retirement/social-security/questions-answers/social-security-earning-full-retirement/
Anspach, Dana, How to Avoid the Social Security Earnings Limit, Sensible Money, December 10, 2020, https://www.sensiblemoney.com/learn/dont-get-pinged-by-the-social-security-earnings-limit/#:~:text=There%20is%20a%20larger%20earnings,in%202020%20it%20was%20%2448%2C600.)
Backman, Maurice, In 2021, you could earn up to $18,960 without having it impact your Social Security benefits, Motley Fool, Oct 25, 2020, https://www.usatoday.com/story/money/personalfinance/retirement/2020/10/25/what-are-the-2021-social-security-earnings-test-limits/42869155/
Retirement Benefits Securing today and tomorrow, SSA.gov, 2021, https://www.ssa.gov/pubs/EN-05-10035.pdf
When can I buy Medigap? Medicare.gov, https://www.medicare.gov/supplements-other-insurance/when-can-i-buy-medigap
Are social security benefits taxable? H&R Block, https://www.hrblock.com/tax-center/income/retirement-income/how-much-of-your-ssdi-is-taxable/
Retirement Benefits Special Earnings Limit Rule, Social Security, https://www.ssa.gov/benefits/retirement/planner/rule.html#:~:text=The%20special%20rule%20lets%20us,regardless%20of%20your%20yearly%20earnings.&text=Reach%20full%20retirement%20age%20in,substantial%20services%20in%20self%2Demployment.
Securing today and tomorrow, How Work Affects Your Benefits, SSA.gov, 2021, https://www.ssa.gov/pubs/EN-05-10069.pdf
Social Security When Should You Start Taking It?
To try to develop the most effective retirement income strategy for the middle class, Stanford University’s Center on Longevity analyzed and compared 292 scenarios.[i]
Its conclusion is a two-prong strategy. First, delay taking social security until age 70 by working either full- or part-time. Second, withdraw annually from your IRAs or 401(k)s based on the IRS’s minimum requirement tables.
Every year you wait after age 66, your social security benefit goes up by 8%. For example, if you are eligible for $30,000 at 66 but are waiting until you reach age 70, that benefit increases by 32% to $39,600. (After age 70, there is no reason to wait because the 8% stops accruing.)
Future cost of living adjustments (COLAs) are then based on the higher amount, which is $39,600 in this example. If the Social Security Administration announces a 2% COLA, your amount next year will be $40,392.
The study recommends that married couples have the higher-earning spouse delay taking his or her social security until age 70 while having the lower-earning spouse begin taking social security when he or she hits the full benefit, which is usually age 66.
That way, if the higher-earning spouse dies, the lower-earning spouse’s social security jumps to the amount the higher-earning spouse was receiving.
The second prong is supplementing your social security by withdrawing from your IRAs or 401(k)s based on the IRS’s required minimum tables. For example, the table might require you to take out 4% of your account value at age 73. If your IRA is worth $100,000, you would withdraw $4,000.
The amount you withdraw each year will change as your account’s value changes and the percentage required to take out goes up.
They recommend keeping between 50 to 100% of your portfolio in stocks. In good years, your withdrawal amount will be higher than when the stock market is down.
The study is based on working until age 70. That way, you will not deplete your IRAs or 401(k)s as you wait. If someone fully retires at age 66, the benefits of waiting to take your social security get more complicated.
Financial Planner Michael Kitce did a study that found it takes to age 80 to break even from having to use retirement assets between ages 66 to 70.[ii]
What About Public Employees?
The study focused on people working for companies that no longer offer traditional pensions, so there is a need for Social Security to replace it.
Most public employees still have traditional pensions. If they retire at age 66 or younger, pension might make it easier to wait for the more significant Social Security payout at age 70.
Other public employees work in one of the fifteen states where some or all their municipal employees do not contribute to Social Security. (Some may become eligible through other jobs.) For them, because of the Windfall Elimination Law, which reduces their Social Security payment by around 55%, why wait until age 70 to get a more significant number decreased by 55%?
Married public employees in those states should be wary of their spouse waiting until age 70 to start taking Social Security, especially if the spouse fully retires at 66.
Why deplete retirement resources, especially if the public employee pension provides a lifetime income guarantee to the spouse upon the death of the public employee? A second law, the Government Pension Offset, means the public employee gets little to none of the spouse’s Social Security after that spouse dies.
[i] Vernon, Steve. How to “Pensionize” Any IRA or 401(k) Plan.” Stanford Center on Longevity. November 2017. http://longevity.stanford.edu/wp-content/uploads/2017/12/How-to-pensionize-any-IRA-401k-final.pdf
[ii] Caplinger, Dan. Social Security: Why the 8% “Return” Myth Shouldn’t Make You Wait to Retire. The Motley Fool, Jun 21, 2015. https://www.fool.com/retirement/general/2015/06/21/social-security-why-the-8-return-myth-doesnt-make.aspx
These are the opinions of Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice