Helping workers make good Social Security choices

Now that employees must fend for themselves when it comes to retirement savings, Social Security’s guaranteed income is becoming even more important.

A new report by Prudential, “Innovative Strategies to Help Maximize Social Security Benefits,” looks at how retirees can maximize their Social Security benefits and make them work for them throughout their retirement.

Many individuals are misinformed about Social Security, the report said, and because of that they make four costly mistakes:

  1. Underestimating the real value of Social Security.
  2. Rushing to collect benefits and then regretting the reduced benefits for the rest of their life.
  3. Not understanding the various ways married couples can integrate their benefits.
  4. Getting blindsided by the “Tax Torpedo.”

“For years, financial service providers have warned us that Social Security will never provide enough income during retirement. While this may be true for many, it is an important component of total retirement income nonetheless,” said the report’s author, James Mahaney, vice president, strategic initiatives for Prudential.

Private employer pension plans are disappearing so Social Security’s guarantees become even more critical to individuals, who may spend 25 to 40 years in retirement. Social Security provides valuable protection against outliving your retirement savings. The paper points out that no Social Security reform proposals to date would impact the benefits of near retirees or those already in retirement, so individuals should take this money into consideration when planning for their futures.

People who take their benefits early don’t think of the future repercussions of that decision. “Most certainly didn’t stop to think that, once reduction penalties as well as foregone Delayed Retirement Credits and COLAs are factored in, they could have potentially doubled their initial payments if only they had waited until age 70,” the report stated.

If you start worker, spousal, or survivor benefits prior to your Full Retirement Age, which varies by age, you will likely be subject to the earnings test. With the earnings test, if you start your benefits early, in every year leading up to the year you reach your Full Retirement Age, $1 in benefits will be withheld for every $2 you earn above the limit for that year ($14,640 in 2012).

During the year you reach your Full Retirement Age (age 66 for those born prior to 1955), your benefits are reduced $1 for every $3 you earn above a higher limit ($38,880 in 2012), until the month you reach your Full Retirement Age. At that point, the earnings test disappears.

If you wait to claim benefits you can take advantage of cost of living adjustments and a delayed retirement credit that will add money to your retirement savings.

Workers who wait until their full retirement age also may qualify for spousal benefits. If a spouse makes less than half of what their partner does they can receive a benefit that includes their own work benefit plus a spousal benefit that in total adds up to half of what the higher-earning spouse will receive in benefits.

Delaying Social Security not only increases an individual’s own benefit, but can also increase the benefit to a surviving spouse. Upon the death of an individual, the spouse will receive the greater of his/her own then-current benefit, including any COLAs; or the deceased spouse’s then-current benefit, including any COLAs, the paper stated.

“Individuals for the most part understand that they face ordinary income taxation of their 401(k)/IRA withdrawals in retirement. Yet the tax situation is often worse for the retiree than expected. Once a very low income threshold is met ($34,000 for singles and $44,000 for married couples), every dollar received from an IRA causes up to 50 percent of a Social Security dollar to become taxed as well.

“At a second threshold, up to 85 percent of a Social Security dollar will become taxable. Assuming a 25 percent federal tax bracket, this creates a marginal tax of 46.25 percent on IRA dollars. Applicable state taxes may push the marginal tax rate to over 50 percent. This situation may get worse if ordinary tax rates increase in the future. The conventional wisdom to always delay, if possible, withdrawals from tax-deferred accounts may not be optimal for many retirees, since they are only creating a greater deferred tax liability due to the high marginal tax rates they may be paying on IRA withdrawals,” according to Prudential.

To avoid this tax nightmare, Prudential recommends taking a higher Social Security income and lower IRA withdrawals when you develop your strategy for taking retirement income.

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