Social Security Traps and How to Avoid Them

Just earlier this week, I came across an article by Kandice Bridges from BankRate.com and found it pretty compelling. The article lays out common social security traps and gives you pointers on how to navigate around them so you don't end up getting taxed on your retirement benefits or face deductions on your payments.

You can start collecting at age 62, but the rules are fairly complex and can impact the dollar benefit that you receive, so let's look at some Social Security "caveats" that everyone should know.

Pitfall #1: Did you know that your Social Security income may be taxable?

If the annual sum of all your income-taxable, tax-free and 50% of your Social Security benefit exceeds $25,000 ($32,000 for married couples filing jointly) then you may have to pay taxes on your Social Security income. Also note that under certain circumstances, up to 85% of your benefits could be taxed.

Also, many seniors like to convert their regular IRAs into Roth IRAs so they can subsequently grow their money tax-free. But beware - this conversion could add to your income from a Social Security perspective so you're always better off converting your IRA to Roth before you start collecting.

Pitfall #2: You must take Required Minimum Distributions

I recently covered Required Minimum Distributions on one of my radio commentaries and have included a link on my website - OnTheMoneyRadio.org. To summarize, once you're over 70 ½ - the IRS stipulates that you withdraw a certain minimum amount from your tax deferred retirement account such as an IRA basically so they can finally get their hands on the taxes you owe them. And these RMDs must be factored into your annual earnings - that $25,000 threshold I just spoke about in Pitfall # 1 - else you risk getting taxed on your benefits. So while you cannot avoid RMDs, I want to make sure you're at least aware of their tax consequences.

Pitfall #3: Some workers do not get Social Security

This may surprise you but many Americans simply do not qualify. For example, certain railroad workers and local, state and federal employees are not covered by social security because they have other retirement pension plans.

The caveat comes in because most of us have held multiple jobs before we turned 60 so it's possible that some of your employers did not pay in to the system. Make sure you look into your paycheck deductions to see if Social Security listed because your expected benefit is based on your contribution history.

Pitfall #4: Early benefits could be a big mistake

While you become eligible at 62, your payable amounts will be small because the government expects to amortize your payout over a longer period of time. But if you wait until you're 70, your benefits actually go up as much as 8% for each extra year that you wait - simply because your money can grow a lot more over 8 years (age 62 to 70) and partly because the government is willing to reward you for delayed gratification.

In addition, social security is annually increased to factor-in inflation so you will get higher inflation adjusted amounts if you wait. And, come to think of it, an extra 8% per year is well above what the stock market delivers so it actually makes good financial sense to hold off on social security benefits till later.

Of course, if you don't see yourself living too long for health reasons, then you might as well collect your benefits sooner but a good general rule is that if you see yourself living beyond 77, you should hold off on social security till you're 70.

Pitfall #5: Windfall elimination provision

Sounds like quite a mouthful, I know, but all it means is this: if you worked for multiple employers and if one or more employers did not participate in social security but had a retirement pension plan instead, then the amount you receive as social security could be less than what your social security statements show - simply because the guys who administer social security (the SSA) only find out that you're eligible for a pension when you apply for your benefits. This is your windfall that the SSA is happy to eliminate by reducing your benefits... and just so you know - this Windfall Elimination Provision (or WEP) was limited to a maximum reduction of $383.50 in 2012.

So, again, look at your employment benefits and make sure you're not planning your financial future on both - your maximum social security benefits plus your pension - and plan for a reduction of about $400 or so and consult your financial advisor so your expenses are in-line with your actual benefits.

Pitfall #6: Limits on benefits while working

Now, you're allowed to collect benefits when you reach 62, even if you have a paying job... but if you make more than $15,120 (in 2013) then your benefits will be reduced by $1 for every $2 you earn above $15,120. So say you earn $6,000 above the $15,120 threshold, your annual social security benefits are reduced by $3,000. That's a pretty severe penalty and a rather low threshold. But it's not all bad... because you get a credit for this reduction and can claim it after you reach full retirement age.

Then when you're between 65 and 67 years of age, depending on your year of birth, you're allowed to earn up to $40,080 and collect full social security. But if you earn more than $40,080, it is deducted 1-for-3... so if you make $6,000 above the $40,080 threshold, you lose $2,000 in benefits under the lose 1-for-3 rule. Of course, this is much better than losing $3,000 in the pre-65 scenario.

And once you reach full retirement age, there is no cap on your income and there are no deductions. So if you plan on working after you're 62 and expect to make more than $15,120 each year, it's in your best interest to defer benefits till you reach full retirement age.

Summary

Social Security is a ubiquitous part of our lives so it makes sense to know the traps and pitfalls which can seriously affect us. I hope I have added just a little more knowledge to help you live your one best financial life.

at 6:53 PM
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