Social Security (SS) is the foundation of retirement planning for almost everyone, and lately it has become a very hot topic in our industry. Each month, this column will tackle an issue central to the coordination of these critical retirement benefits, providing practical insight, tax benefits and lead-generating ideas for wealth advisors to use in the field with prospects and clients.
This first column focuses on introducing key SS rules, definitions and concepts every wealth advisor should know.
To qualify for SS retirement benefits, a worker must have a minimum of 40 credits. For 2014, $1,200 of earnings provides one credit. A maximum of four credits ($4,800) may be earned in one year. A total of 10 full years (40 credits) is required to qualify for retirement benefits.
SS Earnings and Tax
The maximum amount of earnings (employment income) taxable under SS is $117,000. The SS tax is 6.2 percent and is payable by both the employer and employee. Self-employed individuals pay 12.4 percent.
Full Retirement Age
The first step in calculating the retirement benefit is to determine the full retirement age (FRA). The FRA is based on the year of birth. For a worker born between 1943 and 1954, the FRA is age 66. For those born in 1955 or later, the FRA gradually increases to age 67. For the purposes of this article, we’ll assume the FRA is age 66.
Average Indexed Monthly Earnings
The next step is to establish the average indexed monthly earnings (AIME). The highest 35 years of the worker's SS earnings will be used to calculate AIME. A wage index factor is applicable through age 60. This enhances the value of the past SS earnings so that it will provide some correlation to the value of comparable current earnings.
If a worker has been employed for less than 35 years, zero earnings are assumed for those years. If the worker has been employed for less than 35 years, each additional year of employment earnings will increase the AIME. Once a worker reaches 35 years, the AIME will continue to increase if there are higher earnings in subsequent years. Those years will replace years of lower earnings. Even earnings during the retirement years may be used to increase AIME.
Primary Insurance Amount
Retirement benefits are based on the worker's primary insurance amount (PIA). The PIA is the worker’s retirement benefit at FRA. A three-tiered calculation is used to convert AIME to PIA. The PIA is the worker's retirement benefit at FRA. Assume the worker has an AIME of $5,937 in 2014. This would produce a PIA of $2,200:
First-Tier Calculation 90% of $816 = $735
Second-Tier 32% x $4,101 ($4,917 - $816) = 1,312
Third Tier 15% x $1,020 (excess over $4,917) = 153
A worker who’s always had maximum earnings and retires in the year 2014 will have a PIA of $2,643 (includes three years of cost-of living increases (COLAs)).
Starting at age 62, any declared COLAs will increase the worker's PIA regardless of whether the worker is retired. Even in post-retirement years, the COLAs will increase the worker's PIA if the earnings for that year are higher than the lowest year in the 35-year average.
Only COLAs and an increase in AIME will increase a worker's PIA. Once COLAs begin (age 62), the wage indexing is no longer applicable to past earnings and the bend points ($816, $4,917, and the excess over $4,917) in the above calculation are locked in.
A worker may retire as early as age 62. However, because she would be receiving benefits prior to FRA, the benefit will be actuarially reduced. For a worker with an FRA of age 66, the benefit reduction is 25 percent of PIA.
Any worker who takes retirement benefits prior to FRA may be subject to an earnings test. In 2014, any worker receiving benefits before FRA who earned more than $15,480 is subject to the test and a resulting benefit reduction. For every $2 of earnings in excess of the limit, there will be a benefit reduction of $1. In the year the worker reaches FRA, the earnings limit is $41,400, and the reduction is $1 per every $3 of excess earnings. However, all isn’t lost because any excess earnings will be factored into a recalculated higher PIA when the worker reaches FRA.
Recalculation at FRA for lost benefits: If a worker retired and lost 25 percent of the benefits between age 62 and 66 (FRA), at FRA she’ll be treated as though she retired at age 63 rather than 62.
Monthly earnings test applicable in “grace year”: During the year the worker takes early retirement, she may already have considerable earnings, which will cause a benefit reduction when the earnings limit is exceeded. The so-called “grace year” allows the worker to come under a monthly test (rather than annual test) for the balance of the year. In any month the monthly earnings are less than 1/12 of the annual limit, there will be no benefit reduction.
Deferred retirement credits (DRCs) if worker delays benefits until age 70:
The worker may decide to delay benefits until age 70. By delaying benefits, she qualifies for an 8 percent DRC for each year from age 66 to 70. As a result, the retirement benefit will increase by 32 percent.
A worker may obtain her statement on the SS website (www.SocialSecurity.gov/my statement). The statement includes the worker’s earnings record and assumes the current year's earnings to project retirement benefits at the worker's age 62 (early), FRA and delayed retirement at age 70. It also shows the worker's disability benefit, the family survivor benefits and maximum family benefits.
In our next column, we’ll provide a comparison of benefits for early retirement, retirement at FRA and delaying retirement to age 70.
Frank Rainaldi is the creator and primary author of The Kugler System, a marketing and training system used by many major life insurance companies and other financial institutions.
William Rainaldi is CEO and co-founder of The Kugler Company and is co-author and editor of the bulk of the company’s training materials and planning software.