The decision of when to begin receiving Social Security benefits - age 62, age 66, or age 70 - is not an easy one. It involves many variables, much thought, and several detailed calculations.
It is important to understand the difference between Social Security and most other types of retirement accounts.
Social Security vs. Other Retirement Accounts
Social Security benefits are, to a degree, infinite. They continue until you die. Then, if applicable, they continue for any surviving spouse until the spouse passes. You could live to be 137 years old, and each and every month you would receive a full Social Security check.
But if you are single and begin to collect benefits on July 1, and drop dead on July 2, all the contributions you have made to Social Security over your lifetime are lost forever. Your beneficiaries receive nothing.
The value of your Social Security account does not generate "earnings." Your distributions are increased annually based on increases in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).
Distributions from Social Security do not reduce the "value" of your Social Security "account." Except for the consideration of your age when benefits begin, current Social Security distributions do not reduce potential future distributions.
The maximum amount of Social Security benefits that are subject to federal income tax is 85%. The taxable amount could be less. In 27 states, 100% of Social Security benefits are exempt from state income tax.
For the most part (there are exceptions), Individual Retirement Accounts (IRA), 401(k) accounts, and other retirement accounts are finite. At any given time, you can identify the remaining balance in the account. You can at some point run out of retirement account funds.
Any balance left in a retirement account is passed on in full to your beneficiaries, regardless of their relationship to you.
Monies that remain in a retirement account continue to grow tax deferred via the interest, dividends, rents, royalties, capital gains, etc. generated by the individual investments.
Distributions from retirement accounts, again for the most part, reduce the growth of the accounts' balances by reducing potential earnings from accruing.
Retirement account withdrawals, except for qualified withdrawals from a Roth account, could be up to 100% taxable, and, in most cases are, to some degree, also taxable on the state level.
Based on the above information, distributions from Social Security appear to be better than distributions from most retirement accounts.
Example of When to Collect Social Security
Let us look at an example.
Sal Manella, who retired early, needs an annual income of $65,000. He receives a fully taxable $45,000 union pension and has been taking $20,000 from a traditional IRA account, the source of which was a 401(k) rollover. He turns 62 and is able to begin collecting Social Security, which would be about $15,000 per year.
Collecting Social Security at age 62 would mean that he would need to take $15,000 less from his IRA account each year. The IRA is currently yielding a very good annual rate of return. The more money that remains in his IRA, the more the account will grow.
Currently, he is in the 25% federal tax bracket. So $15,000 in IRA distributions would cost $3,750. If he received $15,000 in Social Security benefits the tax would only be $3,188. This results in an annual federal tax savings of $562.
Sal is a resident of NJ. His IRA distributions are fully taxable at 5.525%. Social Security benefits are not taxed on the state level. By replacing $15,000 of taxable IRA distributions with tax-exempt Social Security benefits, he saves $829 in state income tax, bringing his total annual tax savings to $1,391.
If Sal waits until he is 66 to begin collecting Social Security he will receive $400 more per month in benefits. The monthly increase would be even more if he waited until age 70. Sal needs to weigh this loss of future income against the income tax savings and the potential IRA growth that would result from starting at age 62. As I said at the beginning of this article, it is not necessarily an easy decision, and involves many unknowns, such as Sal's life expectancy and future investment performance.
--Written by Robert D. Flach for MainStreet