The Social Security timing debate

Editor’s note: A version of this post previously ran in May 2018. We believe it’s an important topic worth revisiting.

There are a few timeless debates that can really divide a crowd:

• Should you fold a pizza slice before taking a bite?
• Cats versus dogs?
• Is a long sandwich that’s packed with meat, cheese, and condiments a “hero,” “sub,” “grinder,” or “hoagie”?
• Should you defer Social Security?

I’m going to outline my stance on the Social Security timing debate in this blog post. But before I do, I’ll share my point of view on these less important (but arguably just as polarizing) issues: I don’t fold my pizza—I eat each slice slowly and savor every bite. I’m on Team Dog. And I live in New Jersey, so naturally, I enjoy Italian hoagies.

I won’t bury the lede on where I stand on the Social Security timing debate either: I suggest deferring it until age 70 if you can. Tax planning is an important part of any investment strategy, and deferring your Social Security benefit can boost the overall tax-efficiency of your retirement income plan. Here’s how.

Control your taxes now and later

By drawing down traditional tax-deferred assets before collecting Social Security, you can control your taxes both now and later. Your Social Security benefit may be subject to 1 of 3 potential tax treatments depending on your income at the time you collect:

• It won’t be subject to federal income tax.
• Up to 50% of it will be subject to federal income tax.
• Up to 85% of it will be subject to federal income tax.

Let’s say you retire at age 62 and cover your living expenses by taking withdrawals from a tax-deferred retirement account—a traditional IRA. The amount you withdraw from your traditional IRA will lower your account balance. This may reduce your future required minimum distributions (RMDs), which are calculated by dividing your retirement account balance (as of December 31 of the previous year) by the IRS’s life expectancy factor.

Since your RMD is considered ordinary income, smaller distributions can help you control your income when you begin collecting Social Security at age 70. Having a lower level of income at the time you collect will put you in a better position to receive Social Security payments that may not be subject to tax (or are subject to a lower amount of tax). Managing your retirement income in this way can also help you qualify to pay lower Medicare Parts B and D premiums, which are assessed based on your income.

The example below shows how Michael and Patricia, a hypothetical married couple, can decrease their federal tax burden by delaying their Social Security benefits until age 70. (For more information, see our Introduction to Social Security.)

How delaying benefits effects federal taxes

Note: In Scenario 1 above, married couple Michael and Patricia are both age 62. They withdraw $51,000 from IRAs, which is taxable. Based on their earnings history at age 62, 85% of their $24,000 Social Security benefits is taxable. Assuming they have no other income and use the standard deduction, their federal taxes total $5,252. In Scenario 2, at age 70, they withdraw $32,760 from IRAs, which is taxable. Based on their earnings history at age 70, only 34% of their Social Security benefits is taxable, assuming they have no other income and use the standard deduction. Their federal taxes total $2,031. In this scenario, their total taxes are slightly higher in the years before they claim Social Security benefits, but lower taxes after age 70 offset the initial tax cost in less than 2 years.

Get guaranteed income

Nobody can predict the future. But I think it’s safe to assume that as the nation’s population of retirees increases, policymakers will take action to preserve the guaranteed income source that’s been available to most Americans for almost 83 years.

If you wait to collect Social Security, you may fear you won’t get your benefit when you’re ready to collect. However, the complexities of the Social Security system and the variables that can factor into your future benefit amount shouldn’t deter you from creating a comprehensive retirement income plan that supports your long-term goals and incorporates all of your income sources in retirement. Your plan should be based on what you know today—and flexible enough to adapt to legislative changes that come down the pike.

Be realistic about your life span

As an investor, you’re well-versed in aligning your asset allocation with your risk tolerance. You balance your need to achieve your long-term goals with your need to sleep at night. The same is true for deciding when to collect Social Security.

According to the Society of Actuaries, a man who’s 65 today can expect to live, on average, until age 86. A woman can expect to live until age 89.* Because of this, we encourage married couples to consider the odds of at least 1 spouse living into his or her early 90s. And while this average is a good reality check, you should consider personal factors, such as your current health condition, family history, and lifestyle, when thinking about your own life expectancy.

The women in my family have longevity on their side, so I’m pretty comfortable acknowledging that I’m at low risk of passing away before I “break even” for deferring my Social Security benefit. My mom is on a branch of the same family tree, but she isn’t ready to embrace the likelihood that she’ll live to be in her 90s.

The Social Security timing debate is both personal and emotional. It requires you to face your own mortality, weigh potential risks, and make a decision that doesn’t keep you up at night. I plan to defer Social Security until age 70. But in spite of our shared heredity and similar lifestyle, my mom may not come to the same conclusion.

Get a real return

You can claim your Social Security benefit when you reach age 62, but you’ll receive a reduced percentage of your full benefit amount. The percentage you receive is based on how early you collect in relation to your full retirement age (which depends on the year you were born). This reduction is permanent, so your benefit will be reduced for life.

If you collect your benefit at full retirement age, you’ll receive your full benefit amount. If you defer Social Security beyond your full retirement age, it will increase by 8% each year until you reach age 70. The 8% increase is “real,” meaning it’s adjusted for inflation to maintain consistent purchasing power.

Investment returns on money in nonretirement and retirement accounts aren’t guaranteed or inflation-adjusted. So even if you earn an 8% average annual investment return every year for 8 years, there’s no guarantee your investment earnings from year 8 will have the same purchasing power as those from year 1.

Leave a tax-efficient legacy

If you want to leave a financial legacy to your heirs, leave them tax-efficient dollars. The most tax-efficient dollars to bequeath are assets held in Roth accounts, since any distribution an heir takes will be income tax-free. After Roth accounts, assets in taxable accounts are the most tax-efficient dollars to inherit because the cost basis of the investments will be stepped up for the beneficiary. On the other hand, assets in a tax-deferred account, such as a traditional IRA, are less tax-efficient to inherit. Any withdrawal a beneficiary takes will be taxed at his or her ordinary income tax rate.

Your Social Security benefit is only transferrable to your spouse upon your death—which may seem to be a point against deferring. However, most retirees can use a combination of resources, including pensions, annuities, part-time wages, and tax-deferred assets, to replace their paychecks until they turn 70. Then they can use their Social Security benefits (which will have grown 8% a year from the time they reached full retirement age until age 70) to replace some, if not all, of their paychecks for as long as they live.

In exchange for waiting just 4 years (assuming 66 is your full retirement age) to begin collecting, you’ll have a significantly larger benefit to see you through your next 20+ years of retirement.

The hypothetical example below shows the monthly benefit you’d receive based on your age when you begin collecting. Let’s say your full retirement age is 66, and at that time, your full retirement benefit is $2,000 per month. If you delay Social Security, your benefit will grow by 8% each year for 4 years. When you collect at age 70, you’ll get over $600 more each month for the rest of your life.

Monthly benefit based on age you begin to collect

Note: Example excludes inflation.

Continuing with this example, if you defer your benefit until you’re age 70 and live until age 90, you’ll collect $652,560 in Social Security over the course of your lifetime. If you don’t defer your benefit and begin collecting at your full retirement age (66), you’ll collect almost $80,000 less over the course of your lifetime.

Lifetime benefit based on age you collect

Note: Example excludes inflation.

The choice is yours

A timeless debate perseveres because it’s a fair fight—both sides of the argument hold water. Folding your pizza makes it easier to eat; not folding it makes it last longer. Cats are independent; dogs are loyal. No matter what you call it, a sandwich is delicious—so just enjoy it. Taking Social Security at full retirement age means you may be able to preserve other financial resources; deferring until age 70 means you’ll get more money when you do collect.

Several personal factors will likely influence when you decide to collect Social Security. At the risk of sounding morbid, you won’t know whether you’ve truly made the “right” decision until it’s too late. So the best advice I have to offer is to choose your Social Security start date based on the facts you know right now. If you get a good night’s sleep after you’ve made your decision, you’re on the right track.

*Source: longevityillustrator.org, supported by the Society of Actuaries.

Notes:

• All investing is subject to risk, including the possible loss of the money you invest.
• We recommend that you consult a tax or financial advisor about your individual situation.

Source Vanguard Blog