Financial Advisor: How does social security work?
You likely recognize the significance of saving and investing in retirement planning. However, equally vital to the equation is Social Security planning.
The importance of Social Security to retirees cannot be overstated. The reality is that many Americans are not saving or investing adequately for a stable retirement. Without Social Security, nearly 4 out of 10 individuals aged 65 and older would have incomes below the poverty line. On average, this same group relies on Social Security for approximately one-third of their income.
However, there is considerable confusion surrounding Social Security. If you're nearing retirement age, you might be contemplating the best time to claim your benefits. Should you start taking them as soon as you turn 62, or would it be better to wait until later?
On the other hand, if you're in your 20s or 30s, you could be concerned about whether Social Security will deplete its funds before you even receive any benefits. Social Security goes beyond being solely a retirement program. It serves as a vital support system for individuals with disabilities, the families of deceased workers, and the dependents of beneficiaries.
This article will focus on Social Security retirement benefits. Retirees make up the largest group of people who receive these benefits.
How are benefits calculated?
The calculation of your Social Security benefits relies on three main factors: your work history, the 35 highest-earning years of your career, and the age when you choose to begin receiving benefits. Although Cost of Living Adjustments (COLAs) play a role, their impact is relatively minor in comparison.
Regarding your work history, you earn one Social Security credit for every $1,640 you make in 2023. However, the maximum number of credits you can earn in a year is four. Achieving an income of $6,560 in 2023 will grant you the full four credits for that year.
Once you accumulate a total of 40 credits, you become eligible for benefits upon reaching retirement age. In essence, working full-time for ten years classifies you as "fully insured" for retirement benefits.
Social Security determines your benefits based on the 35 years when you earned the highest income. The maximum income considered for calculation is $160,200 in 2023, which is an increase from $147,000 in 2022. Any earnings beyond $160,200 in a year are not subject to Social Security taxes. Whether you made $1 million or $1 billion in 2022, it would count as $160,200 for Social Security calculations.
If you worked for less than 35 years, they would still count 35 years of earnings. But for the years you didn't work, they will assume you earned nothing. This could lower your monthly benefits if you retired early or had long periods without work.
When calculating your monthly retirement income, they consider your earnings and adjust them for inflation. This calculation provides you with your average monthly earnings. This gives you your average monthly earnings.
You can claim benefits as early as 62, but you'll receive a reduced amount. Alternatively, if you delay claiming until age 70, you'll receive larger monthly checks.
If you choose to get Social Security benefits early, your monthly checks will be smaller. The amount is reduced by about 0.56% for each month before your full retirement age. This means your monthly benefits will be about 6.66% less for each year you claim early.
On the other hand, if you wait past your full retirement age to claim, Social Security rewards you with an extra 8% for each year you delay until age 70, when benefits reach their maximum. Waiting until 70 for Social Security gives a 76% higher monthly benefit than claiming at 62.
Can you take Social Security based on your spouse's record?
Certainly! You can get Social Security benefits from your current spouse, deceased spouse, and sometimes even an ex-spouse.
You can't get benefits from both your own work record and your current or ex-spouse's work record. You must decide if you want benefits based on your work record or their work record. Choose the option that gives you more benefits.
You have the option to collect Social Security benefits based on your current spouse's record if the following conditions are met:
You've been married for at least a year.
Your spouse is already receiving their benefits.
You are at least 62 years old, or you are caring for a child who is under 16 or disabled.
Benefit amount: You can receive 32.5% to 50% of your spouse's benefit.
If your spouse has passed away, you can collect benefits from their record if:
You are at least 60 years old, or you are 50 and disabled. Alternatively, you can qualify if you are caring for the deceased spouse's child.
Your marriage lasted for at least nine months, except in cases of accidental death or death in the line of military duty.
You did not remarry before age 60 (or age 50 if you are disabled). However, if you remarried later, you can still collect benefits from your late spouse's record.
Benefit amount: You can receive 71.5% to 100% of your late spouse's benefit.
If you're divorced, you may collect benefits based on your ex-spouse's record if:
Your marriage lasted for at least 10 years, and you have not remarried.
You've been divorced for at least two years.
You are at least 62 years old.
Your former spouse is eligible for benefits, even if they haven't started claiming them yet.
Benefit amount: You can receive 32.5% to 50% of your ex-spouse's benefit.
If you claim benefits from a divorced spouse's record, their monthly benefits won't be reduced. Additionally, if your ex-spouse has been married multiple times, there's no need to compete with other exes at the Social Security office. All of you can claim based on their records if you choose to do so.
What's the average monthly benefit?
As of January 2023, the average Social Security benefit stands at $1,827 per month. For individuals who retire at full retirement age, the maximum possible benefit reaches $3,627 per month in 2023. However, those who choose to wait until age 70 can receive an even higher amount, up to $4,555 per month.
It's essential to keep in mind that only the highest-earning workers will be eligible for these maximum benefit amounts.
Is Social Security enough to retire on?
For an average earner, Social Security is expected to replace approximately 40% of their pre-retirement income. However, financial planners typically advise aiming to replace around 70% to 80% of pre-retirement income during retirement. To achieve this goal, it is important to save for retirement. This can be achieved by making contributions to a 401(k) scheme or investing in a Roth IRA or a conventional IRA.
Although Social Security isn't intended to be the sole income source during retirement, the reality is that many older Americans heavily rely on it. According to the Center on Budget and Policy Priorities, about 50% of elderly individuals rely on Social Security for a minimum of half of their earnings, and nearly one-seventh of retirees depend on it for 90% or more of their income. This highlights the significance of having additional sources of retirement income beyond Social Security.
Who pays for social security?
Both you, as a taxpayer, and your employer contribute to Social Security funding. Social Security is funded through payroll taxes, often known as FICA taxes.
Typically, most workers have 7.65% of their paychecks automatically deducted for FICA taxes. Of this, 6.2% of your earnings are taxed for Social Security on the first $160,200 of your income as of 2023. Income above this threshold is not taxed for Social Security. $160,200 is the highest amount used to calculate benefits.
The remaining 1.45% of the 7.65% goes towards Medicare, and there is no salary cap for Medicare contributions. In fact, individuals earning over $200,000 and married couples with income exceeding $250,000 pay an additional 0.9% Medicare tax.
Your employer matches your 7.65% contribution for both Social Security and Medicare. Self-employed people pay 15.3% of their income because they must cover both the employee and employer contributions.
Is Social Security going broke?
This is not entirely accurate.
The truth is, Social Security is facing a critical juncture. Since 2021, the program's expenses have exceeded its funding due to increased life expectancy and declining birth rates. As a result, fewer individuals are contributing to the system.
Despite having a substantial $2.9 trillion trust fund, these funds are projected to be exhausted by 2035. However, this doesn't imply that the program is destined to fail. Social Security operates on a pay-as-you-go model, meaning the current workforce's contributions finance the benefits of current retirees.
As the trust fund gradually depletes, Social Security will continue to receive payroll taxes from workers and employers. Even if the trust fund runs dry in 2035, the ongoing payroll taxes would still generate sufficient revenue to cover approximately 79% of the program's obligations if Congress does not intervene.
Nevertheless, there are various actions that Congress could take to avert potential Social Security cuts. They could choose to raise taxes, remove the wage limit, or increase the retirement age, like in 1983.
The likelihood of Congress taking no action is relatively low. According to a survey conducted by Pew Research Center, 74% of Americans are opposed to reducing benefits. Politicians from both parties are aware that voters have a strong affinity for the program.
Can you work and claim benefits?
After you reach full retirement age, you can work without affecting your Social Security benefits, no matter how much you earn.
However, if you choose to take Social Security benefits before reaching full retirement age, your benefits will be subject to reduction. For every $2 you earn above $21,240 in 2023, your benefits will be reduced. When you reach full retirement age, $1 will be withheld for every $3 you earn above $56,520. Once you reach full retirement age, your benefits will no longer be subject to any reduction, regardless of your earnings.
Are Social Security benefits taxed?
If you have additional income from a job or investments, there is a possibility that a portion of your Social Security benefits will be subject to taxation. Here's how it works:
For single filers:
0% of your benefit is taxable if your income is below $25,000.
Up to 50% of your benefit is taxable if your income falls between $25,000 and $34,000.
Up to 85% of your benefit is taxable if your income exceeds $34,000.
For married couples filing jointly:
0% of your benefit is taxable if your combined income is below $32,000.
50% of your benefit is taxable if your combined incomes range from $32,000 to $44,000.
85% of your benefit is taxable if your combined income surpasses $44,000.
It's important to note that "taxable" does not necessarily indicate the exact amount you pay in taxes. If you earn $30,000, the IRS sees your income as $20,000. $20,000 is from Social Security benefits and $10,000 is from 401(k) withdrawals. This includes 50% of the Social Security benefits plus the $10,000 from your 401(k).
If you are still working and saving for retirement, consider utilizing Roth IRAs and Roth 401(k)s. If you choose not to take tax breaks while working, you will receive tax-free money when you retire. This will not have any impact on your Social Security taxes.
If the $10,000 came from a Roth IRA instead, the IRS would consider your income as $0 in the given example. This would place you below the $25,000 income threshold, resulting in 0% of your Social Security benefits being taxable.
If your only source of income is Social Security, you likely won't have to pay taxes on it. This is especially true considering that the average annual benefit is around $21,924.
What's the best age to take Social Security?
Determining the perfect age to claim Social Security benefits is not a one-size-fits-all decision. Unfortunately, there are individuals who are eagerly seeking benefits due to early retirement caused by health issues, unemployment, or caregiving responsibilities. These people are unable to wait patiently for assistance. The reasons for their early retirement include health problems, job loss, or the need to support a family member.
If your priority is receiving larger monthly payments, waiting as long as possible to claim benefits would be the best approach. If you want more frequent but smaller checks in your life, you should think about claiming benefits sooner. The choice ultimately depends on your personal financial goals and circumstances.
If you have medical concerns or a history of early parental deaths, it may be worth considering starting Social Security benefits earlier. On the other hand, if you are in good health and have concerns about your financial longevity, waiting as long as possible to claim benefits might be more suitable.
Some couples use a strategy to get the most benefits. The spouse who earns more waits longer to claim benefits, while the spouse who earns less claims benefits at 62. When the higher-earning spouse starts collecting, the lower-earning spouse can switch and start getting half of their benefits. This approach can be beneficial in optimizing Social Security benefits for couples.
Can you get benefits if you haven't worked?
Even if you have never worked, you can still receive Social Security retirement benefits based on the record of your current, former, or deceased spouse. However, if you have not paid into the system, you will need to contribute to be eligible for benefits.
Children of a deceased worker can qualify for survivors' benefits until they reach 18 years old. If they are still enrolled in high school full-time, the benefits can extend until they turn 19. Additionally, if the child is over 18 but has a disability that started before age 22, they may also be eligible for survivors' benefits.
Can you reverse your decision to start benefits?
Yes, however, the opportunities to reverse your Social Security decision are quite restricted. If it's been less than a year since you started receiving benefits, you have the option to withdraw your application. To do this, you must repay all the benefits you've received, including Medicare premiums, taxes withheld, and any benefits your family received on your behalf.
Once you reach full retirement age, you have another option. You can suspend your benefits, allowing you to benefit from the additional 8% increase in your Social Security benefits for each year you delay beyond your full retirement age. When you turn 70, your benefits will automatically resume.
Bottom Line
Social Security benefits is not an easy thing to understand. Consulting with a financial advisor or financial planner can be helpful to make sure you have a clear understanding of your options when it comes time to apply for Social Security.
Sources:
https://www.thepennyhoarder.com/retirement/how-does-social-security-work/
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