Why 2018's Social Security COLA May Really Be Just $1

More than 66 million Americans will see a 2% increase in their monthly Social Security and Supplemental Security Income (SSI) benefits in 2018. But many will see their take-home pay stay about the same as it was in 2017.

In dollars and cents, the average retired worker's monthly benefit will rise $27 to $1,404 in 2018 from $1,377 in 2017. But depending on what happens with Medicare premiums, many people could see little or nothing of that 2% COLA, said Elaine Floyd, director of retirement and life planning at Horsesmouth.

By way of background, the SSA deducts the Medicare Part B premium, which helps pay for physician, outpatient hospital, home health, and other services for the aged and disabled who have voluntarily enrolled, from a Social Security beneficiary's monthly check. In 2017, about 70% of Medicare beneficiaries paid $109 per month for Part B and 30% paid $134 or more. Read more about Medicare costs.

"Even if the Part B premium stays the same next year at $134 per month, which is what Medicare trustees projected in their 2017 report, people who were held harmless in previous years because their COLA did not cover their Medicare premium increase will see a jump in their personal premium because their COLA will now cover some or all of it," said Floyd.

For determining an individual's monthly Part B premium rate, there is a hold-harmless provision in the law that limits the dollar increase in the premium to the dollar increase in an individual's Social Security benefit, the Medicare trustees noted in their most recent report. This provision applies to most beneficiaries who have their premiums deducted from their Social Security benefits, or roughly 70% of Part B enrollees in 2016 and 2017.

Floyd gave this example: Take someone who is receiving a Social Security benefit of $1,300 a month and whose Part B premium is $109 because they were held harmless in past years. Their 2% COLA would amount to $26 a month. If the new base Medicare premium is $134, they would now have to pay the full amount because the $26 COLA would cover the $25 increase (from $109 to $134), leaving them with a $1 increase in their net Social Security check.

Ironically, Floyd said, it is the people with lower benefit amounts who are most likely to encounter this phenomenon because they are more likely to have been held harmless in years past. "In other words, they've been getting a break on their Medicare premiums in order not to have their Social Security checks reduced due to small COLAs in years past, and that break is now being taken away because of the higher COLA this year," she said.

Read Social Security Claiming Strategies: How to get the biggest check

Meanwhile, people who have been paying the full $134 premium will see their entire 2% COLA, plus or minus any change in the Medicare premium, Floyd said. "With more people now able to pay some or all of the full premium, not just the 30% of beneficiaries who are not held harmless, we could actually see a decline in the base Part B premium," she said. "That's what happened in 2012, when the COLA jumped to 3.6% following two years of 0%."

"People who had been held harmless since 2009 were paying $96.40, while those not held harmless paid $115.50. Thanks to the 3.6% COLA, everyone could now pay the new base premium, which caused it to drop to $99.90. The people who had been held harmless didn't really notice that their 3.6% COLA was reduced by $3.50 to account for the higher Medicare premium. But this year, barring a substantial drop in Medicare premiums, which is unlikely, people who were previously held harmless will notice that their Social Security checks next year are the same as they were this year. 'Where is my COLA?' they might ask. The answer is that it got snatched by Medicare," she said.

When it Takes Effect

The 2% percent cost-of-living adjustment (COLA) will begin with benefits payable to more than 61 million Social Security beneficiaries in January 2018 and increased payments to more than eight million SSI beneficiaries will begin on Dec. 29, 2017, the Social Security Administration (SSA) announced last week. The SSA notes that some people receive both Social Security and SSI benefits.

The Social Security Act ties the annual COLA to the increase in the Consumer Price Index (CPI) as determined by the Department of Labor's Bureau of Labor Statistics. The COLA has averaged 3.75% since 1975, but just 1.2% since 2010.

According to the Bureau of Labor Statistics, CPI has averaged 1.63% per year since 2010 and prices in 2017 are 12 higher than prices in 2010. In other words, $1 in the year 2010 is equivalent to $1.12 in 2017, a difference of $0.12 over seven years.

According to the SSA, some other adjustments that take effect in January of each year are based on the increase in average wages. Based on that increase, the maximum amount of earnings subject to the Social Security tax (taxable maximum) will increase to $128,700 from $127,200. Of the estimated 175 million workers who will pay Social Security taxes in 2018, about 12 million will pay more because of the increase in the taxable maximum.

Information about Medicare changes for 2018, when announced, will be available here.

By way of background, at the end of 2016, the Old-Age, Survivors, and Disability Insurance (OASDI) program was providing benefit payments to about 61 million people: 44 million retired workers and dependents of retired workers, six million survivors of deceased workers, and 11 million disabled workers and dependents of disabled workers.

The OASDI program consists of two parts. Retired workers, their families, and survivors of deceased workers receive monthly benefits under the Old-Age and Survivors Insurance (OASI) program. Disabled workers and their families receive monthly benefits under the Disability Insurance (DI) program.

Actionable Advice for Future Beneficiaries

For those who will become beneficiaries in the future, Theodore Sarenski, the CEO and president of Blue Ocean Strategic Capital, had this advice: "Look at the COLA over the past 10 years. We are in a low-interest, low-inflation environment and the Federal Reserve says they want to keep inflation at 2%. Social Security, which was never meant to be your sole source in retirement, will grow slowly. A person will need to save more themselves."

Sarenski also said future beneficiaries should expect healthcare costs to continue rising at least double the inflation rate, as measured by the Consumer Price Index or CPI. According to the Federal Reserve Bank of St. Louis, since 1948, the price of medical care has grown at an average annual rate of 5.3% while the entire basket, headline CPI, has grown at an average annual rate of 3.5%. In the past 20 years, in the regime of stable inflation, headline CPI has grown at an average annual rate of 2.2%, whereas the price level of medical care has grown at an average annual rate of 3.6% -- about 70% faster. Read more about this from the St. Louis Fed.

Given that, Sarenski said pre-retirees should be saving at least 15% of their income currently. Another goal, he said, would be to have 15 times what you earn in a year saved by the time you retire. This number was suggested to be 12 times a few years ago but lower returns and interest rates since 2000 have caused this multiple to rise to 15.

Of note, Fidelity suggests that pre-retirees aim to save at least 1x their income at age 30, 3x at 40, 7x at 55, 10x at 67. In 2015, Aon Hewitt suggested that 65-year-old would need 11 times their final salary saved for retirement.

As for those who will start benefits after 2030, Sarenski had this warning: Expect Congress to act on stabilizing Social Security, as it is expected to only pay 79% of expected benefits in 2034 and beyond. "Nothing substantial will happen prior to 2030 in Social Security legislation," he said. "Just look at Washington since we turned the millennial."

According to the 2017 Social Security Trustees report, the OASI Trust Fund reserves are projected to become depleted in 2035, at which time OASI income would be sufficient to pay 75% of OASI scheduled benefits.

At Retirement's Doorstep?

As one approaches retirement, Sarenski suggests looking for places to retire that cost less than where you are living while working. "Be sure to look at all costs, not just state taxes," he said. "Look at local taxes, sales tax, school tax, costs of basic goods like food and fuel, access to travel and other personal wants that you currently enjoy. Look for a place near good healthcare as this is something you will be using more and more as you age."

Prepare for a Longer Life

Americans are living longer, and as such, proper planning for retirement income - including the decision when to claim Social Security -- is critical, said David Cechanowicz, a senior financial planner with REDW Stanley Financial Advisors.

Cechanowicz said pre-beneficiaries should crunch the numbers to determine when to claim Social Security. "The larger issue is that those who have not yet claimed their benefits need to meet with a professional who can help them understanding the claiming options that are available to them," he said. "This is especially important for dual income households since there are two sets of claiming rules, one set for those born before Jan. 2, 1954 and a second for those born on or after Jan. 2, 1954."

Claim Early vs. Claim Later

A financial adviser who can help with Social Security claiming advice should also be able to explain the long- and short-term income tax consequences of claiming decisions," said Cechanowicz. "Claiming early versus claiming late will change the balance and ratio of Social Security benefits, which are tax preferred, to other taxable income, such as IRA withdrawals, capital gains, and qualified dividends."

In some cases, he said, the income tax benefits from a well-structured retirement-income plan can be almost as valuable to a couple in retirement as the extra income that they can receive from an optimized Social Security claim.

Cechanowicz noted that retirees with Social Security benefits can be exposed to the highest marginal income tax rates in the U.S. "An individual that decides to take an extra $5,000 or $10,000 out of an IRA account may think that he or she is in a 10% or 15% income tax bracket," he said. "But come tax time the sad reality may be that 55.5% of the additional withdrawal can be lost to federal tax, with state taxes piled on."

Create Tax-Efficient Income

Others agree about the need to create tax-efficient income. Although the 2% increase for Social Security beneficiaries may seem small, Joe Elsasser, president of Covisum, said the indexation of the thresholds for taxable Social Security benefits is always zero.

That means, Elsasser said, that each increase in Social Security benefits due to COLAs puts more of the population in a situation where each additional dollar withdrawn from a retirement account subjects a larger amount of Social Security benefits to taxation. So, for someone in a 15% tax bracket, this can mean an effective marginal rate of 27.75% on each additional dollar withdrawn from a retirement account.

Elsasser's advice: "Check to see if the full 85% of your Social Security benefit is already taxable. If not, check with your tax and financial advisers to identify ways to reduce the portion of benefits that is subject to tax as it will have an outsized positive impact on your tax bill. If so, there may still be strategies available for significant tax savings, but they won't be nearly as apparent."

How might you reduce the portion of benefits that is subject to tax? Elsasser offered up these suggestions:

  • For someone who is still working or a couple in which at least one member is working, an IRA contribution can save not just the tax that would have been paid on the contributed amount but also remove 85 cents of a Social Security dollar from taxation. And, if they also have taxable capital gains on their return, there are times they can actually save upward of 55%.
  • Another strategy is to carefully select which accounts to draw from when. For example, using some funds from an IRA and some from a brokerage or savings account that include a return of principal to meet an overall income need can keep Social Security tax to a minimum.
  • A third might include using proceeds from a reverse mortgage to reduce necessary withdrawals from IRAs, again reducing the amount of withdrawals and in turn taxable Social Security benefits.
  • A fourth might include using tax-deferred products such as annuities or life insurance to exert more control over when growth is realized for tax purposes.

"The options are many, so working with an adviser who is equipped with tools for both Social Security and tax planning is important," said Elsasser.

"The COLA announcement is a good reminder for pre-retirees to plan, plan early, and plan smart," said Cechanowicz.

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