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Social Security Plays Role in Retirement Planning

Filed under Personal Finances. Fact checked on July 31, 2012.

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While the talk of Social Security's future and solvency is always up for debate, you'll want to familiarize yourself with the program, your retirement benefits and how it will affect your golden years.

Political debate and writing about the financial health of the Social Security system is a perennial topic among policy wonks and the evening news. 

Based on what you've heard, you may have complete faith that the system will prevail and be able to continue providing social benefits. Or, you may believe that the system will collapse and fall into complete financial ruin and you'll never collect your benefits. The role Social Security will play in your retirement plan depends on your opinions about the system's continued viability and on what action the government takes between now and the time you retire. 

The Social Security Administration's pamphlet Understanding the Benefits (PDF) reminds us: "Social Security was never meant to be the only source of income for people when they retire."

What Is "Social Security"?

When first adopted, Social Security covered about 60 percent of the work force. Over the years, it has expanded coverage to include the self-employed, many state and local government employees, federal workers and employees of nonprofit organizations. Today, approximately 95 percent of all workers are covered by Social Security.

The program was designed to be a self-supporting federal program, financed with payroll taxes and providing not just retirement income, but a host of other insurance programs as well. There are four distinct types of benefits provided:

  • Retirement benefits, which you can elect to receive at any time after age 62, are based on the number of years that you have worked and the amount of money you have earned. Your spouse and, in some cases, your children may also be eligible for benefits based on your earnings records. Coverage has also been extended to ex-spouses if the marriage lasted at least 10 years and the ex-spouse has not remarried.
  • Survivor's benefits are a form of life insurance, providing payments to your spouse and dependent children after your death.
  • Disability insurance provide you a monthly income if you are unable to work because of an illness or disability, regardless of age.
  • Medicare provides both hospital insurance (Part A) and voluntary medical insurance (Part B) for men and women over age 65 and disabled younger people. An HMO type plan is dubbed Part C and Part D is the relatively new prescription drug plan which works through private insurance similar to Part B, but nowhere near as comprehensive—yet.

These benefits are financed by payroll taxes, broken into two components of "Social Security" taxes: 

  • Old Age, Survivor and Disability Insurance (OASDI) 
  • Medicare Hospital Insurance (HI)

For employees, these components are called the Federal Insurance Contribution Act (FICA) tax, and half is paid by the employee and half by the employer. For calendar year 2013, the OASDI employee portion is 6.2% of the employee's wages, while the employer's portion is 6.2%, for a total OASDI tax of 12.4%. The HI tax is 1.45% for both the employee and the employee.

For self-employed individuals, the tax is called the Self-Employed Contribution Act (SECA) tax, and "both halves" (employer & employee) are paid by the self-employed individual. For calendar year 2013, the SECA tax rate is 12.40% for OASDI and 2.9% for HI, resulting in a total tax burden of 15.3%.

The OASDI portion of both FICA and SECA is capped at $117,000 of wages for 2014. However, all compensation is subject to the 2.9% HI tax. Under certain circumstances, Social Security benefits may be subject to income tax, as discussed below.

Meeting the SSA Credits Requirements

A person who works and pays Social Security taxes earns Social Security credits. In 2014, one social security credit was received for each $1,400 of earnings, up to a maximum of four credits per year. In future years, the amount of earnings needed for a credit may rise if average earnings levels in the country rise. The credits earned remain on the Social Security Administration's records, even if you change jobs or have a period of no earnings.

If you were born after 1928, 40 credits are needed. Most people will earn many more credits than they need to qualify, but these extra credits do not in themselves increase the size of your monthly social security benefit. It is the amount of income earned while working that determines the size of the retirement benefits.

You may qualify for Social Security benefits as a wage earner or as a spouse of a wage earner, even if you are divorced, so long as you were married 10 years or more and have not remarried. Spouses' benefits are generally equal to half of the amount of the primary wage earner's benefit. In some cases, your benefit as a spouse may be larger than your benefit as a wage earner. If you've been married, Social Security will pay you the higher of either your own benefit, or half of your spouse's benefit. Unfortunately, you can't get both.

Eligibility is Based on Credits for Wages and Lifetime Earnings

Your benefit as a wage earner is based upon your "average indexed monthly earnings" (AIME). This index is simply a history of your lifetime earnings as it is maintained in the records of the Social Security Administration (SSA).

If you were born after 1928, your AIME is based on your highest paid 35 years of work. This includes work for yourself, as well as work for employers who are covered by Social Security and time spent in the military. The Social Security system assumes a 40-year career and uses the 35 years of the highest earnings to compute your AIME. If you did not work the minimum number of years, you will be adding zeros into the average, thereby greatly reducing your AIME and subsequent benefit amount. If you work more than forty years, the SSA will still use your 35 highest-paid years.

Determining Your Estimated Benefits

Your Social Security benefit will be based on the Social Security Administration's record of your earnings. The SSA sent annual Earnings and Benefits Estimate Statements to people who meet all the following criteria:

  • who have worked in Social Security-covered employment or self-employment
  • who are not yet receiving benefits
  • for whom the SSA can find a current mailing address

Starting in October 1999, the SSA began mailing Earnings and Benefits Estimate Statements to workers age 25 and older every year about three months before their birth month. The statement showed the amount of annual wages and self-employment income credited to a person's account through their lifetime.

Perhaps even more importantly for various planning purposes, workers also received an estimate of their Social Security retirement benefits. Estimated payment amounts were provided based on retirement at various ages, (for example, age 62 and 70). Also included was the approximate monthly payment one would receive if they became disabled, and how much an individual's family would receive if the person died.

This comprehensive information was put on temporary hiatus, and the SSA suspended mailings of benefits earning statements. For a brief window, you could only use an SSA-provided online calculator to estimate your Social Security contributions and expected payouts. The SSA did, however, resume mailing statements on February 2012 to workers 60 or older not already collecting benefits. The agency claims it will resume mailing statements to all workers 25 and older, but no concrete date has been released.

Rather than waiting for postal mailings, you can access your Social Security Statement online through the SSA website at http://www.ssa.gov/mystatement/.

Keeping Track of Your Earnings Records

At the very minimum, you should view your online Earnings and Benefit Estimate Statement every three years to be certain the SSA has maintained accurate information. 

In most cases, the SSA by law can correct errors only up to three years, three months and 15 days after they occur. If you don't get a copy of your earnings history every three years and review it, you won't catch errors in time for correction.

What Is Your Retirement Age?

You have a choice of when to begin collecting your Social Security retirement benefits. You can take early retirement benefits, normal (full) retirement or hold off for late retirement. 

At the earliest, Social Security retirement benefits can begin at age 62. Normal retirement begins at 65, 66 or 67 depending on the year you were born. Or you can wait until age 70. The age at which you begin collecting is one of the factors in determining the amount of your monthly benefits.

Tip

In the 1980s, in order to increase the stability of the system, the "normal" or "full" retirement age was increased in the normal or full retirement age from 65 to 67. While the increase is gradual and relatively small, it represents a major change in Social Security philosophy. The age-65 retirement limit for full benefits had not been changed since the adoption of the Social Security Act in 1935, even though life expectancy for a 65-year-old then was only another 2 years. Today the life expectancy of a 65 year old is another 16 years for a man and 19 years for a woman. In 1935, when Social Security was enacted, most people never reached age 65.

Your Early Retirement Options

If you take early retirement, your monthly benefit is reduced depending on the number of months between your early retirement and your normal retirement. The maximum reduction is currently set at 30 percent. The following table can be used to calculate how early retirement will affect your monthly benefit.

How Early Retirement Will Reduce Monthly Benefits
Months Early % of Full Benefits Months Early % of Full Benefits Months Early % of Full Benefits
2 98.9% 22 87.8% 42* 77.5%
4 97.8% 24 86.7% 44* 76.7%
6 96.7% 26 85.6% 46* 75.8%
8 95.6% 28 84.4% 48* 75.0%
10 94.4% 30 83.3% 50* 74.4%
12 93.3% 32 82.2% 52* 73.3%
14 92.2% 34 81.1% 54* 72.5%
16 91.1% 36 80.0% 56* 71.7%
18 90.0% 38* 79.2% 58* 70.8%
20 88.9% 40* 78.3% 60* 70.0%
* These percentages apply as full retirement age rises to 67.

Although each monthly check is smaller, you will probably get more of them, so even at reduced levels, amounts collected between 62 and full retirement age may result in greater total benefits. However, you must look at your overall retirement plan. The money you make by continuing to work past 62 may possibly exceed the Social Security benefits you'd receive during the early retirement years and qualify you for higher benefits later with a bigger payout from another pension or profit-sharing plan.

Your Normal (Full) Retirement Options

You can receive full benefits by waiting until you attain normal or full retirement age. Full retirement age is rising in stages to age 67 for people born between 1938 and 1960.

Age at Which Full Benefits Are Available
Year of Birth Full Retirement Age
Before 1938 65
1938 65 and 2 months
1939 65 and 4 months
1940 65 and 6 months
1941 65 and 8 months
1942 65 and 10 months
1943 through 1954 66
1955 66 and 2 months
1956 66 and 4 months
1957 66 and 6 months
1958 66 and 8 months
1959 66 and 10 months
1960 and later 67

Your Late Retirement Options

You also have the option of postponing your retirement—or, more precisely, the collection of Social Security benefits—beyond your full retirement age. Uncle Sam gives you an added incentive to stay in the work force by giving you a bonus for each year you delay collecting benefits. The increase is to compensate for the years you did not receive Social Security.

For people reaching full retirement age in 2008 and beyond, the rate is 8 percent per year. Keep in mind, though, that you will no longer earn this delayed retirement credit after you reach age 70.

Late Retirement Bonus
Year You Were Born Annual % Increase in Benefits
1917-1924 3.0
1925-1926 3.5
1927-1928 4.0
1929-1930 4.5
1931-1932 5.0
1933-1934 5.5
1935-1936 6.0
1937-1938 6.5
1939-1940 7.0
1941-1942 7.5
1943 or later 8.0

From an actuarial viewpoint, delaying the collection of social security benefits is usually thought to be an unwise financial move. But for women, delaying retirement may be worth it. It depends on a number of factors.

  • If you haven't worked the full 35 years used in the benefits calculation, working a few more years will add considerably to your earnings base.
  • If your salary during your last working years is high, this will also raise your earnings base.
  • Women live longer than men, and thus are likely to receive benefits longer than the average man, even if receipt is delayed beyond age 65.

Social Security Benefits May Be Taxable Income

Depending upon your total annual income, a portion of your Social Security benefit may be subject to income tax. If the total of your taxable pensions, wages, interest, dividends, other taxable income and any tax-exempt interest income plus half of your Social Security benefits are more than a base amount, some of your benefits will be taxable. 

Your base amount depends on the filing status on your US tax return Form 1040. The base amount is $25,000 for single and head of household filers and $32,000 for those married filing jointly. These dollar amounts are not indexed for inflation.

The amount of your Social Security benefits that you must include in taxable income depends on the total of your income plus half of your benefits. The higher the total, the more benefits that must be included in taxable income. You may have to pay income tax on anywhere from 50 percent to 85 percent of your social security benefits.

And remember, that's how the law stands now. By the time you retire, it's possible that all benefits will be taxable, or none of the benefits will be taxable.

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