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When should you start your Social Security benefits?

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Retirement & Social Security, Part 6

The rules that govern Social Security benefits are presented in the usual bureaucratic fashion that makes it hard to be informed and easy to become misinformed. We’ll attempt to wipe away the cobwebs of confusion and give you the easy-to-understand rules that will allow you to make good decisions.

Since Social Security provides lifetime benefits, the decision you make regarding when to start benefits has profound implications. The lifetime benefits you’ll receive are determined by when you start them and the annual adjustment made for inflation.

Benefits grow each year they’re deferred and the inflation adjustment is also applied. If you start at age 62, the earliest possible time, your monthly benefits will be permanently reduced by 20 percent or more. If you start at the latest permitted time, age 70, your permanent benefits could be more than 50 percent higher than at the normal retirement age.

The normal retirement age is determined by your year of birth. If you were born in 1937 or earlier the normal retirement age is 65; normal retirement age increases two months per birth year from 1938 through 1942; normal retirement for birth years 1943-1954 is 66; for birth years 1955-1959 it again increases two months per birth year; from 1960 and later the normal retirement age is 67.

Your annual benefits are also linked to and adjusted annually for the cost of living as measured by the general change in prices. Since the inflation adjustment is linked to the general change in prices rather than the basket of goods that is purchased by the typical retiree, the Cost of Living Adjustment (COLA) applied to your benefits may come up short because medical care expenses are a larger portion of retirees’ budgets.

Over the past two decades medical care cost has risen an average of 5.6 percent annually whereas overall inflation has averaged 3.15 percent. While the Social Security COLA may not be keeping pace with “your” inflation, remember that most income you’ll have access to in retirement has no automatic adjustment for inflation.

According to the Social Security Administration, 72 percent of current Social Security recipients receive reduced payments because benefits were started before normal retirement age. This has resulted because many have needed their benefits early to sustain their lifestyle. Sadly, many others started taking benefits before normal retirement age simply because the benefits were available, not because they were needed; little thought was given to the impact on total benefits during their lifetime and that of their spouse.

Many opting for early benefit thought, or were convinced by their broker, that the money could be invested and earn more than the benefits typically grow each year when deferred. The go-go markets of the late 1990s have not continued and many early recipients hoping to realize higher earnings have actually incurred losses. Not only have the realized benefits been smaller but the taxes have been higher than if they had deferred taking Social Security benefits.

The cardinal rule of investing says to never take a risk if you can’t afford the worse-case outcome. Make sure you understand this rule before taking your Social Security benefit early so you can direct the investment. The average expense ratio for a mutual fund (the most preferred investment place for retirees) is about 1.5 percent and hidden fees from trading and other brokerage costs are about 1 percent. Add to these the not-unusual 1 percent fee that many financial planners charge, and you need a 3.5 percent earnings rate just to break even. That’s before adjustment for inflation.

If you add the 3.15 percent average annual inflation, you have a sizable 6.65 percent return just to break-even in real terms before taxes and you can’t generate this level today without taking risks. In fact, safe investments are paying 5 percent or less at the current time.

Before you step out on the risk curve to earn the needed 6.65 percent after tax, remember 2000-2002, and before that 1973-1974, when the market indexes declined by as much as 50 percent and practically everyone who owned stocks, mutual funds and other securities lost heavily.

At the same time, Social Security benefits were rising about 7 percent to 8 percent for every year delayed over the normal retirement age and receiving cost of living adjustments on top of that. They continue to post similar growth today.

Can you think of a 100 percent safe investment for your money that realizes a 7 percent to 8 percent annual return plus are adjusted for inflation annually and get preferential tax treatment?

The fact is that postponing benefits beyond normal retirement to age 70 can substantially boost benefits and lessen your taxes — neither of which is possible by taking benefits early and speculating in the market. The traditional focus on when to take Social Security benefits has been break-even, i.e., how long will it take for the higher benefits to offset the later start? For the record this break-even age for most is around age 77-78, but that’s not the issue because there can be benefits that exceed your lifetime. This break-even short-sightedness discounts the value of an annual COLA, the tax preferences, spouse’s benefits, potential widow’s benefit and a proper consideration of the normal life expectancy.

Too often the conventional thinking has been: “I’d better take my Social Security benefits as soon as I’m eligible because I might not live very long and waiting could mean I’ll get fewer or no benefits.” This may be justified if you’re in poor health and don’t have to worry about spousal benefits.

For the record, the “break-even analysis” shows that starting later with higher benefits is best for normal life expectancy. Parenthetically, life expectancy is an “average” and means that roughly one-half of the individuals with the same life expectancy will live longer than expected.

How does the decision of one spouse to take or defer Social Security benefits affect the other spouse? Here’s the rule: a spouse is entitled to receive the greater of (a) their own Social Security benefits, or (b) 50 percent of their spouse’s benefit available at the normal retirement age. This is important if one spouse worked only inside the home and did not pay into Social Security or if one spouse has qualified for more than twice that of the other.

If in such cases the higher-qualifying spouse receives lower payments by starting benefits early and then dies before the lower-qualifying spouse, the surviving spouse will receive lower benefits for the remainder of his or her life. Since 2000, a spouse wishing to delay benefits beyond normal retirement age can “file for and then suspend” benefits so the lower-benefit spouse can qualify for one half of the higher-qualifying spouse’s benefits. The lifetime differences can be profound, especially in the case of premature death of the higher-qualifying spouse.

The second-stage rule says that a surviving spouse will receive the greater of (a) his or her own benefits plus COLA or (b) the deceased spouse’s benefits plus COLA. Accordingly, if financially possible it may make sense for the lower-qualifying spouse to start taking benefits as early as possible and the higher-qualifying spouse to delay as long as possible. At the death of the higher-qualifying spouse, the benefits to the surviving spouse will be stepped up to the higher level of benefits.

A married couple should consider joint longevity when deciding the time to take Social Security benefits. If the husband is the primary breadwinner and also is older or has a shorter life expectancy, he should delay benefits as long as economically feasible whereas the wife should start benefits at age 62 when first eligible.

This snowball lives on and could go a long way in helping widows and widowers have a better retirement. By arbitrarily taking Social Security benefits when first eligible at age 62, the spousal benefits are totally discounted. The resulting financial cost is very high in cases when the lower-qualifying spouse substantially outlives the higher-qualifying spouse. Spouses should take age differences and the relative size of early, normal and delayed benefits into account in timing when to commence Social Security benefits.

I will be happy to answer any questions you may have or arrange for a free consultation.

Edward Fusco can be reached at Harbor Village Professional Center, 18 Main St., Townsend, MA 01469. Call (978) 597-9177 or take a look at what everyone is raving about at www.sbr.retirerx.com.

This information is provided for informational purposes only and may not be suitable for every situation.