A Crash Course in Social Security Maximization

Cost of living increases, claiming age, marital status and work history all complicate Social Security claiming strategies.

Art by Melinda Beck

The conventional wisdom about how someone should draw down their various assets to maximize retirement income—used by many of the big recordkeepers in their retirement tools and calculators—is that a person should take all their taxed money first until it’s gone, and only then draw down tax-deferred money. Then, a person should take the tax-exempt dollars.

According to William Meyer, founder and managing principal of Social Security Solutions, this rule of thumb is pervasive, but new analytical tools show this is actually typically the opposite approach of what would maximize lifetime wealth for a given individual.

Why is this? According to Meyer, when one retires, on average he will indeed drop into a lower tax bracket, because he is moving out of his prime earning years and instead starting to live off savings. But when this individual soon reaches and starts drawing full Social Security at 70—likely just a few years after retirement—that’s right about the time when required minimum distributions (RMDs) kick in. When that happens at age 72 1/2, many retirees’ income jumps pretty significantly, and as a result the Social Security benefits that they waited so patiently to claim will be taxed at potentially up to 85%, because this rate is based on overall income including withdrawals from tax-deferred retirement accounts, Meyer warns.

Given this fact, by instead first winnowing down the tax-deferred 401(k) or IRA assets, while waiting to file for full Social Security, this potentially reduces the lifetime impact of RMDs and reduces the taxes, potentially quite significantly, on the net income from Social Security.

As Meyer and others agree, Social Security claiming is always a complicated matter to discuss in the abstract, but there are some general rules and principles to know. The first consideration when it comes to maximizing Social Security income is to work for at least 35 years, as the benefit takes into consideration one’s highest 35 years of income history. The second, even more important consideration, is when to start taking Social Security. Benefits are reduced by up to 25% if an individual claims before full retirement age, but are increased by up to 35% if a person delays claiming past full retirement age, up to age 70. Roughly speaking, every year one waits to take Social Security, the benefit goes up by 8%.

Experts agree that the better one’s health and the longer the individual and spouse expect to live, the more it makes sense to take Social Security later—as long as they are not putting strain on investments. Another factor is employment. If someone plans to continue working, it may make sense to delay taking Social Security, as benefits are reduced by $1 for every $2 earned before full retirement age. This changes to $1 for every $3 earned at full retirement age for earnings over $45,360.

Recently, Edward Jones published an analysis that found that if a person decided to start taking Social Security early, at age 62, their first annual benefit would be $18,000. By age 80, adjusted for a 3% cost-of-living increase every year, that would reach $30,633. For a person whose full retirement age is 66 and starts Social Security that year, their benefits would start at $26,988 and rise to $40,812 by age 80. Someone starting their Social Security benefits at age 70 would receive $40,092 in the initial year and $53,783 by age 80.

Kimberly Blanton, author of the Squared Away Blog published by the Center for Retirement Research at Boston College, says one area where workers are not making the most of Social Security is the spousal and survivor benefits. She points to the fact that two out of three men and women in a recent survey by RAND were unaware of the fact that a divorced person who was married for at least 10 years is entitled to a deceased spouses’ survivor benefit. In fact, the divorced spouse would even get the benefit if the other spouse had remarried, Blanton notes.

“In the case of couples who were still married when the spouse died, the marriage had to last only nine months for the survivor to get the benefit,” Blanton says. “Fewer than half of the people surveyed by the RAND researchers were aware of this rule.”

According to Blanton, there is also little understanding that the Social Security survivor benefit is based on the higher-earning spouse’s work record. Today, this is still typically the husband, meaning that a wife who used to work and is collecting Social Security based on her work record is eligible to switch to her husband’s greater benefit after he dies.

“To make the switch in this particular case, the widow must file with the Social Security Administration either online or at a local office,” Blanton says. “If the wife never worked and is at retirement age, she will automatically start receiving her late-husband’s check.”

Blanton says that unmarried partners sometimes operate under a misconception too.

“Three out of four think, incorrectly, either that unmarried people can get the survivor benefit, or they don’t know,” she says. “One thing to note about this study is that Americans of all ages were surveyed, and it is not surprising that young adults would have little knowledge of program benefits intended for widows. But age doesn’t seem to bring wisdom. The results were equally dismal in a similar earlier survey of individuals who were at least 50 years old.”

Just over one-quarter of adults think they can live comfortably on Social Security alone, according to a survey by the Nationwide Retirement Institute. The survey shows 70% think they are eligible for full benefits before they actually are. On average, they incorrectly think they will be eligible for full benefits at age 63, and 26% think that even if they claim early and receive lower benefits, these benefits will rise once they reach full retirement age.

On average, retirees say they began collecting Social Security at age 62. The reason they gave for taking Social Security benefits early were to pay for living expenses (61%), to supplement their income (36%), or because they faced health issues (22%).

“Social Security is one of the most confusing retirement topics that America’s workers are facing today,” says Tina Ambrozy, president of sales and distribution at Nationwide. “Our survey reveals that fewer than one in 10 older adults know what factors determine the maximum Social Security benefit an individual can receive.”

Sixty-six percent of future retirees worry about Social Security running out of money in their lifetime. Forty percent think there will be cuts under the current administration, and 83% think the Social Security system needs to be reformed.