The decision on when to claim social security is complicated enough when retirement comes at the normal retirement age. You’ll need to think about health conditions, personal preferences, spousal benefits, and of course, your social security benefit amount. But when your goal is to leave the rat race as soon as possible, you add another layer to the decision-making process. You’ll need to fund those early retirement years and think about healthcare! The decision on when to claim your social security takes on even more importance.
Receiving Social Security requires qualifying for the benefits. This means having 40 quarters of work credit in most cases, which is the equivalent to a decade of employment.
Social Security has three tranches: Retirement, Disability, and Survivors. You cannot claim a retirement benefit until you are at least 62 years old. The amount you receive is a combination of how much you earned during your career, how many years you worked, and when you decide to collect benefits.
Each of those factors is important in determining your payout, but when you decide to claim is by far the most sensitive. The Social Security Administration (SSA) considers your highest 35 years of earnings when calculating your benefit. This means that hanging on and working an extra year will factor in as just 1/35 of your work and earnings history! That in and of itself won’t move the needle.
But having an extra year to let your benefit grow and an extra year without distributions from your retirement accounts? That does have an impact.
The Importance of your Full Retirement Age (FRA)
Your FRA is the age at which you qualify for your full retirement benefit. Claim sooner and you receive a lesser benefit. Wait and claim a larger benefit.
But your FRA varies by date of birth. Those born between 1943 and 1954 have a full retirement age of 66. Those born between 1955-1959 exist on a graded scale, and everyone born 1960 or later can claim full benefits at age 67:
|If you were born in:||Your full retirement age is:|
|1955||66 and 2 months|
|1956||66 and 4 months|
|1957||66 and 6 months|
|1958||66 and 8 months|
|1959||66 and 10 months|
Data source: Social Security Administration
The reason for different claim dates is down to politics and longevity. Increases in longevity grew faster than what actuaries predicted, which created an income deficit in the system. Rather than raise taxes to plug the shortfall, policymakers pushed out the full retirement age.
The FRA dictates the accretion or subtraction in your benefit amount, but it also matters for the earnings test.
The Earnings Test for Social Security Early Retirement
Claiming Social Security before your Full Retirement Age will subject you to the earnings test. This is a pernicious little piece of law that restricts your Social Security benefits if you continue to work and earn above certain thresholds. The more you earn, the more that is withheld.
There are two different exempt amounts, and both are indexed for increases in line with the National Average Wage. This is the amount you can earn before the earnings test kicks in. The first exempt amount is $19,560 and it applies to people reaching their full retirement age after 2022. The second exempt amount is $51,960 and it applies to people reaching FRA during 2022.
The first, lower exemption amount only applies to earnings made after retiring. The second, higher exempt amount only applies to earnings made in the months before reaching full retirement age.
How the Test Works
It’s pretty simple. For the lower threshold applying to those who aren’t hitting their FRA this year, the Social Security Administration withholds $1 of benefits for every $2 of earnings above the limit. This changes to $1 of benefits withheld for every $3 of earnings at the higher threshold covering those hitting their FRA in the current year. If you make enough money and claimed early, the SSA can withhold your entire benefit!
Consider Damon, who retires at 63 in March having earned $40,000 in salary year to date. A former colleague approaches him about some light consulting work and Damon earns another $55,000 in fees following retirement. Not having anticipated a second act in retirement, he already turned on social security to avoid taking money from his retirement accounts. He collects just over $1,500/mo in payments.
Damon’s exempt amount is $19,560. This means he will have $95,000 – $19,560 = $75,440 subject to the earnings test. The Social Security administration will withhold $35,440 / $2 = $37,720 of annual benefits. But Damon only receives $1,500/mo for nine months (retired in March), which is $9,000. Damon will have his full benefit withheld for the year!
The impact would be negligible if he waited to claim the year he hits his FRA, where the higher exemption amount applies. Remember, this exemption amount only applies to the money earned prior to full retirement age in the year in which you hit your full retirement age. If Damon retires in March with $40,000 of salary, hits his FRA in June, and gets his first consulting payment in July, then he won’t owe a dime back to the SSA! The timing of cash flows is very important this year. He will only tip the scale if his salary and consulting income breach those higher amounts.
How the Test is Applied
The Social Security Administration must have an idea about how much you’re going to earn in order to apply the earnings test. The only way for them to get this information is for you to communicate it to them, either with a phone call or at the end of the year in a tax return. They will not come beat down your door to ask if you’re earning money and if so how much. It’s up to you to identify the issue and work to rectify it.
Sadly, the website doesn’t allow you to update your earnings estimate. This must be done with a phone call or an in-person visit, and the phone call is the faster method by a country mile.
Consider Damon and his consulting gig once more. The SSA will discover how much income he earned for the year when he files his taxes if he doesn’t call and provide an earnings estimate sooner. They’ll see the $95,000 he made and the $9,000 they paid him when they should have been withholding benefits. The solution? Damon sees his future social security checks withheld until the SSA is able to collect on the amount they should have withheld.
Fortunately, the money Damon pays back isn’t lost. Its not a penalty or anything punitive. The earnings test is merely a disincentive to keep people from double-dipping on both wages and social security. Whatever is withheld is tacked back on to increase his social security payments at his full retirement age.
So, since Damon retired 3 years early and had an entire year’s worth payments withheld/paid back, when paychecks resume his payout will be higher and look like he retired just two years early. In fact, it is likely to be just slightly higher than that. He will have one extra year of earnings to factor into his 35 highest years of earnings when determining his payout. The difference won’t be huge, but he’ll still get credit for it regardless.
There is a rule to help people like Damon, who get tripped up with the earnings test in their first year of retirement. Instead of an annual earnings test, the SSA can apply a monthly earnings test instead. Under this rule, Damon can receive a full Social Security check for any month he’s fully retired (subject to the exemption amount) while ignoring the amounts he made from his pre-retirement employment from January – March. Damon will be considered fully retired if his monthly earnings stay at $1,630 or less, or 1/12 of the $19,560 exemption amount.
The $95,000 from the previous example is obviously more than this, but he wouldn’t have any issues if he kept his consulting income to a minimum. This may be difficult with his project-based work, though. If there is a month that Damon breaches the $1,630 limit, the SSA will simply withhold his payment for that month. He can resume receiving his social security check the following month if his income dips back down below the $1,630!
What Income is Counted in the Earnings Test
Only earned income is considered when applying the earnings test. This is wage income from a job, self-employment income, or income from a business in which you have an active role in the day-to-day operations. Investment income, pensions, annuities, rental real estate, and Roth conversions don’t factor into this. Neither do the Social Security payments you receive.
Some types of income may be taxed the same way, but that doesn’t mean they are all treated the same way for the earnings test. Also, retirement plan contributions and IRA contributions won’t work in reducing your income for purposes of the test. You still pay FICA tax on these and they are still considered when running the earnings test.
Other Unique Considerations
Business owners may have unique cash flows and ways of paying themselves. Only net earnings from self-employment are considered as income from this group. Additionally, income counts when you receive it and not when you earn it. This is a big deal.
You may send out an invoice in November when work was completed, but if your client doesn’t pay you until January it won’t count towards the social security earnings test for that year. This leaves some creative opportunities for year-end planning, though this author generally isn’t a fan of being slow paid.
The opposite is true for employees: income counts when you earn it, not when you receive it. This means that your last two weeks of pay in December still count towards your yearly total for the earnings test even though you won’t actually receive payment until sometime in early January.
Additionally, you have the ability to suspend social security payments. This may seem like a more convenient fit than having to call and communicate with the SSA on a routine basis about your income. But suspension is only an option for people who have already reached their full retirement age and are no longer subject to the earnings test in the first place!
The Impact of Waiting for the FRA or Beyond
Waiting to your FRA to claim benefits has a few advantages. First and foremost, you don’t see a reduction in the level of benefits paid. Claiming retirement benefits within 36 months of reaching your FRA will see a reduction of about 0.56% for each month claimed early. This sums to 20% if you claimed exactly 36 months early.
If you claim even earlier than three years from FRA, you’ll go through the full 20% reduction mentioned above plus another 0.42% reduction for each month claimed early. That works out to another 5%/year. So, if your full retirement age is 67 and you claim at age 62, you’ll experience a whopping 30% reduction in the level of benefits paid!
The sword cuts both ways on this; deferring your claiming decision past your Full Retirement Age will see your benefit increase by just shy of 8% for each year you wait to claim. You cannot defer past age 70.
The Impact to your Spouse
Spousal benefits and survivor benefits based on your earnings record can also be paid out to family members. However, claiming early (or deferring until sometime after full retirement age) doesn’t impact their level of payout. That’s because these benefits are calculated from your Primary Insurance Amount (PIA), which is dictated by your earnings history. Your decision to take benefits early doesn’t change your PIA.
However, both the survivor’s benefit and the spousal retirement benefit will be reduced if your spouse claims early. Your claiming decision won’t reduce their benefits, but their claiming decision certainly will.
The Bottom Line
Your unique circumstances will determine the right way to incorporate your Social Security benefits into your financial strategies during retirement. Factors that determine when you decide to begin collecting Social Security include your health status, your cash-flow needs, you and your spouse’s retirement plans, and when you and your spouse reach full retirement age. If you want to retire early, consider strategically drawing down other sources of funds first. This allows you to delay claiming benefits for as long as possible, which can earn you more in the long run and give you more control over your taxable income.