One of the greatest questions when you are planning for retirement is where is the income going to come from. When the salary and/or hourly wages come to a stop, where is the money coming in from. From a financial planning standpoint, this is one of the most important questions that we plan for. Will we be pulling money monthly from tax-free accounts such as Roth IRAs and Roth 401(k)s? If so, how much? If there are pre-tax accounts such as traditional IRAs and 401(k)s it must be determined how they will be used and if income will be taken from them. It is possible that annuities are present in the plan and a fixed amount will be distributed as income from them as well. All of these options, and the taxability of their withdrawals, are taken into consideration when income planning for retirement. Often times Social Security is used to supplement a retiree’s income in retirement. Whether a person was unable to save as much as they had hoped or they want to preserve capital for future generations, Social Security fills in gaps in many people’s plans.
When we are planning for the long-term, we do not like to place massive importance on a person’s estimated Social Security income. Instead of relying on Social Security, the goal for most retiree’s is to be independent from it if they want to be. This obviously does not work in cases where we start planning with someone later on in their life who is closer to retirement and does not have the savings to draw income purely from. The other example that we mentioned earlier is that Social Security is often used as income to help ease the amount being withdrawn from invested assets thus helping preserve capital. In any case, Social Security is something that needs to be factored into your retirement planning. Planners need to think about when they will need to start taking this income and when it is even possible to do so. Social Security is taxed different than other income, and this needs to be planned for as well. The biggest question people usually have is in regards to how much they will get paid from Social Security. How does one calculate that monthly income number? Let’s talk about all these questions and give a quick refresher on the ins and outs of Social Security.
Social Security Factors and Eligibility
A person’s Social Security Income in retirement will be based upon the money they made during their working lives. The government, namely the Social Security Administration, uses a system called “Average Indexed Monthly Earnings” to determine the benefits that will be paid to an individual1. In this system, up to 35 years of an individual’s earnings are averaged and then applied to a formula which determines their monthly payment. This monthly payment is called a person’s Primary Insurance Amount (PIA)1. An individual must obtain at least 40 work “credits” in their lifetime to be eligible for full social security retirement insurance. Credits are earned based on a person’s annual earnings. The amount of earnings that are required each year to obtain work credits is adjusted each year to track wage inflation. In turn, each year your monthly benefit amount once you have applied receives a cost-of-living adjustment as well. A person cannot apply for Social Security retirement benefits until they are 62 years old. There are exceptions to this rule for people with disabilities. As I am sure you have heard, the longer you wait to take those benefits the larger the monthly benefit amount will become. While you can start getting those benefits at 62, you can choose to what to apply until age 70 which will allow for greater benefits. This is a major factor to discuss and plan for when financial planning. Choosing when to decide to take Social Security is totally dependent on someone’s personal situation. Some people may choose to wait until 70 because they want the full benefit amount and more. Some will take the income before the full benefit age because they need the income as a part of their budget. The next question then is how are these benefits taxed?
Social Security Income Taxability
Despite the fact that you pay into this program your entire working life via a deduction from your paycheck, your Social Security Benefits may still be subject to federal income tax. For individual filers with a combined income between $25,000 and $34,000, you are eligible to be taxed on up to 50% of your SSA benefits. If your combined income is over $34,000 you may have to pay taxes on up to 85% of your benefits. For married filers, you may have to pay federal income taxes on up to 50% of your benefits if you make between $32,000 and $44,000. Married filers with over $44,000 of combined income may be taxed on up to 85% of their benefits. The IRS defines your combined income as your Adjusted Gross Income (AGI) + Nontaxable Interest + ½ of your Social Security benefits. In an example, let’s say you are an individual tax filer who has a combined income of $29,000. You received $24,000 in benefits this year from the SSA. In this example you could be taxed at most on only $12,000 of those benefits. This does not mean that you would owe a 50% tax on your benefits, you wouldn’t owe $12,000. This simply means that only 50% of your benefits can be taxed as federal income rather than the full $24,000. When planning for retirement income and separating your sources of income into different buckets, SSA benefits would be categorized in a pre-tax bucket rather than an after-tax bucket. While saying that, many people take Social Security as their only income and thus have a combined income below $25,000 or the $32,000 guardrail for married people. In these scenarios benefits would not be taxed, but it is good to plan as if they will be.
How to View Estimated Benefits and Start Application Process
While you could look up the formula used by the SSA and use your Average Indexed Monthly Earnings to calculate your full monthly benefits, there is an easier solution. By visiting the Social Security Administration’s website, which is linked below, you can create for yourself an account and estimate your future benefits using the software they have created. Creating an account is free and you can also use that account to apply for benefits online when the time comes.
Social Security can be somewhat confusing at times with some of the rules and stipulations that are tied to it. For all the information about this topic that you could ever want, follow the link below to the Social Security Administration’s website. Hopefully this blog gave a brief refresher on how these benefits could factor into your retirement! As always, it is best to reach out to your financial professional if you have any questions regarding when you want to take Social Security and how it will factor into your budget. We are happy to help!
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss. All examples are hypothetical and do not take in the effect of taxation, they are for illustrative purposes, only.