Archives for November 2012

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Will I Hit the Maximum Social Security Benefit if I Wait to Claim?

A reader writes in, asking:

“I am 66 years old and if I took SS now, my monthly benefit would be $2,241. I’ve read on the SSA website that there’s a maximum benefit for 2012 of $2,513. If I wait to take my benefit, will I hit the limit before 70?”

In short, no, you will not hit a maximum benefit limit as a result of waiting to claim your Social Security retirement benefit.

The maximum benefit figure you see on the SSA website is not really a maximum benefit. Rather, it’s a maximum primary insurance amount. That is, it’s the maximum retirement benefit a person could receive if he/she claimed that benefit in 2012 at his/her full retirement age.

If a person’s primary insurance amount was already at the maximum level, then she waited four years (from her full retirement age of 66 until age 70) to claim that benefit, the amount she would receive per month would be 32% greater than the $2,513 maximum benefit figure provided on the website.

Why Is There a Maximum Primary Insurance Amount?

The fact that there’s a maximum primary insurance amount isn’t the result of a separate rule specifically imposing a maximum. Rather, it’s a result of the fact that, each year, there’s a maximum amount of earnings that are subject to Social Security taxes (e.g., $110,100 for 2012). In other words, the $2,513 figure for 2012 is simply the primary insurance amount that you would have if you had earned (at least) the maximum amount subject to Social Security tax for the last 35 years.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

Selling Investments to Pay Down a Mortgage

A reader writes in, asking:

“I currently have a variable home equity line of credit (now at a 4% interest rate). We’ve currently borrowed $150,000 on the HELOC. We have about $850K in investments, mostly with Vanguard. How do I decide whether to pay off the loan, dropping my investments to $700K, when it seems I make about 5% on the investments?”

One way to look at the situation is that you’re simultaneously borrowing money at 4% while lending money to somebody else at a rate equal to the yield of the bonds in your portfolio. (For a Vanguard Total Bond Market holding, that would be about 1.5% right now.)

That would certainly suggest that it would be a good idea to liquidate some of your bond holdings in order to pay off the loan. But there are a few counterpoints that should be considered first.

Comparing (After-Tax) Apples to (After-Tax) Apples

The line of credit’s after-tax interest rate is likely lower than 4% when you consider the value of any deduction you’re currently getting for the interest. In contrast, if your investments are completely tax-sheltered (i.e., not in taxable accounts), then there would be no need to reduce the interest rate on your bonds in a similar fashion for comparative purposes. In other words, the spread between the two interest rates may not be as high as it appears at first glance.

Paying to Maintain Liquidity

In some cases, it makes sense to simultaneously borrow money at a higher rate than you’re earning on your lowest-earning holdings because doing so allows for greater liquidity, which offers a degree of protection against unexpected large expenses.

In this case, however, that’s unlikely to be a concern given that:

  1. The line of credit would still be there, available for a cash crunch, even if you paid it down, and
  2. A mutual fund portfolio well into the 6-figure range provides plenty of liquidity as well.

Additional Tax Considerations

Another thing to consider is the tax consequences that would result from liquidating holdings in order to pay off the line of credit. The answer to this depends on:

  • Where the investments are held (e.g., Roth IRA vs. traditional IRA vs. taxable account),
  • Your age and current tax bracket (if they’re held in a tax-deferred account), and
  • Your cost basis in the investments (if they’re held in a taxable account).

For instance, if the investments you would be liquidating are all in tax-deferred accounts, even if you do decide you want to go ahead and pay off the loan, it might make sense to do it over 2-3 years rather than all at once, because such a large distribution in one year from a tax-deferred account would likely bump you into a higher tax bracket, and the additional taxes paid (relative to spreading it out over 2-3 years) might outweigh the interest saved.

What About Borrowing to Own Bonds and Stocks?

Finally, some people would argue that the appropriate comparison is not the interest rate on your bond holdings as compared to the rate on the line of credit, but rather the average return on your total portfolio as compared to the rate on the line of credit — with the reasoning being that having the bond holdings is what allows you to have the stock holdings without exceeding your emotional/mental tolerance for volatility.

Should I Own Any Sector Funds?

A reader writes in, asking:

“Under what circumstances would it be advantageous to own one of Vanguard’s sector funds? Their energy fund for instance has done very well over the last 10 years.”

With one exception (which we’ll discuss momentarily), I think few investors have compelling reasons to use sector funds.

The reason why most investors shouldn’t bother with sector funds is the same as the reason why most investors shouldn’t bother with individual stocks. That is, each of the different industries (and most of the individual stocks) that make up the market are already included in a “total market” index fund. So it only makes sense to overweight a particular industry (or stock) if:

  • You are meaningfully different from the average investor in some way such that the market portfolio is not a good fit for you personally, or
  • You have some information that the market doesn’t have (or doesn’t fully understand) about the industry or stock in question.

For example, with regard to the first point, it would theoretically make sense for most investors to want to underweight the particularly industry that they work in. That is, it would make sense for most investors to have a smaller-than-average allocation to stocks in that industry. The benefit of doing so would be that it reduces the correlation between their job safety and their portfolio performance — thereby reducing the possibility of a particularly bad scenario in which their portfolio tanks at exactly the same time that they get laid off.

In the real world, however, that strategy falls apart due to its impracticality. To create a portfolio that’s market-weighted aside from a smaller-than-average allocation to one industry, you’d have to craft a patchwork portfolio of funds representing each of the other industries. Doing so would result in a lot of extra hassle, additional room for error, and higher expenses (because most sector funds have markedly higher costs than “total market” funds).

With regard to the second point, it’s a bit of a Catch 22. In the rare event that you really do have some information that the market doesn’t have or doesn’t fully understand, there’s a good chance that the reason you have that advantage is because of your work. For example, if you work in the healthcare industry, you might have reason to think that the market is underestimating the future growth of that industry. But the natural conclusion (i.e., to overweight healthcare stocks in your portfolio) is dangerous for exactly the reason discussed above — having your portfolio performance closely tied to your job safety is generally not a good thing.

What about REIT Funds?

Several experts have made the case that, unlike other sector funds, funds owning real estate investment trusts (REITs) warrant an additional allocation beyond what would already be included via a “total market” fund. For example:

  • David Swenson makes the case for REITs as a diversifier because their performance is often more closely tied to the real estate market than to the rest of the stock market, and
  • Rick Ferri argues that you would need a specific allocation to REITs if you wanted your portfolio to reflect the whole economy (rather than just the publicly traded portion), given that privately owned real estate is such a huge part of the economy.

Personally, I would be happy with or without a specific REIT allocation.

Do Not Try This Social Security Strategy

Earlier this month, I attended a CPA continuing education course about Social Security. I was surprised to find the following statement in the course’s text*:

“The most overlooked benefit in two-earner situations is the possibility of both spouses electing a spousal benefit. This requires each spouse to have claimed his or her own retirement benefit so the other can claim the spousal benefit.”

The book then provides an example:

“Jack and Jill are both 66. Jack has a PIA of $2,500, Jill a PIA of $2,000. [Mike’s note: “PIA” stands for “primary insurance amount,” and it refers to the size of your retirement benefit if you claimed it precisely at your full retirement age.] Jill can claim and suspend yet receive a spousal benefit of $1,250. Jack can claim and suspend and claim a spousal benefit of $1,000.”

The book then explains that each spouse can thereby allow his/her own retirement benefit to continue growing until age 70, at which point they can ask to have payments unsuspended.

Unfortunately, this strategy doesn’t work. And by trying to implement it, the couple could lose out on $60,000 of benefits that they could have collected between age 66 and 70 if just one spouse (ideally, Jack) had filed and suspended while the other spouse had filed a restricted application (for just spousal benefits) at full retirement age.

Why This Strategy Doesn’t Work

The reason the strategy proposed above does not work is that you cannot collect a spousal benefit if you are “entitled” to a retirement benefit or disability benefit and your primary insurance amount is greater than 50% of your spouse’s primary insurance amount.

To be “entitled” to a benefit in the way the Code of Federal Regulations uses the term, you must have filed for the benefit. And, after you have filed, even if you ask to have payments suspended, you are still “entitled” to that benefit (even though you will not be receiving the actual payments).

So, in the book’s example of Jack and Jill, both spouses — having filed for their retirement benefits — would be entitled to a retirement benefit that is based on a PIA that’s greater than 50% of their spouse’s PIA. As a result, neither spouse would be eligible to receive a spousal benefit.

In contrast, if you haven’t filed for your own retirement benefit (and you’ve reached your full retirement age), it’s possible to file a restricted application for just spousal benefits, while allowing your own benefit to grow. In other words, in the book’s example, if only one spouse had filed and suspended, the other spouse would be able to file a restricted application for just spousal benefits — thereby allowing both retirement benefits to grow until age 70 while one spouse receives a spousal benefit in the meantime.

*I’m intentionally omitting the name of the course provider and the book. My goal is not to criticize but simply to make sure that people know not to try this strategy.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

How Far Does $300,000 of Retirement Savings Go?

This week I came across a recent survey by Wells Fargo which found (among other things) that when middle class Americans were asked how much savings they would need in order to support themselves in retirement, the median reply was just $300,000. That’s a much lower savings target than you typically hear discussed in financial media. And the press release about the survey sure seemed to indicate that the figure wasn’t high enough.

But just what kind of lifestyle can $300,000 of retirement savings support? I suspect it’s a higher standard of living than much of the financial services industry would have you believe.

What Level of Income Could We Expect?

With $300,000 in savings, if we assume a withdrawal rate of 4% per year, we get just $12,000 of annual spending. Fortunately, personal savings is not the sole source of income for most retirees.

As of 2012, the average monthly Social Security benefit for a retired worker is $1,230. In the case of a married couple, we can add $615 (half of $1,230) to account for a spousal benefit. (Of course, for unmarried people, there would be no second benefit. On the other hand, in a married couple in which both spouses worked, the total benefit would likely be higher.)

When we multiply the sum of those two monthly benefits by 12, we get a total of $22,140 in annual Social Security benefits.

$22,140 of Social Security, plus $12,000 in spending from savings gives us $34,140 of annual income.

And It’s Probably Tax-Free

Unlike the wage income and self-employment income that most people earn throughout their working years, Social Security benefits and investment income are not subject to payroll taxes.

In addition, at that income level, none of the Social Security benefits would be included as taxable income for federal income tax purposes. And the $12,000 of spending from savings — even if we assume it’s coming entirely from tax-deferred accounts — would be free of federal income tax as well because it would not exceed the standard deduction and personal exemptions.

How Far Does $34,000 Go?

Admittedly, given the high price of medical expenses and other day-to-day costs, $34,000 of income for a married couple doesn’t leave a lot of room in the budget for taking the family on cruises around the world — even if the $34,000 is tax-free.

On the other hand, it’s not poverty either, especially when we account for the facts that:

  1. There’s no need to carve a piece of that income out for retirement savings, and
  2. Many retirees (roughly 53% of U.S. citizens age 65 or older, as of 2009 [1][2]) own their homes and carry no mortgage debt.

There’s Still Cause for Concern

In my opinion, the primary cause for concern here isn’t that the $300,000 goal is too low. The bigger problems are that:

  1. Many savers won’t meet that goal due to insufficient savings rates, poor investment decisions, and unplanned early retirements, and
  2. Many retirees — even if they do meet their savings goals — will spend from their savings at too high a rate. (According to the study, when asked what percentage of their savings they expect to withdraw annually in retirement, the median answer was 10%.)

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

Social Security Planning with Widow(er) Benefits

A reader writes in, asking:

“My husband passed away in 2009. I’m currently 59. Do the claiming strategies discussed in your book change at all for somebody who would be receiving widow benefits instead of spouse benefits?”

Yes, they do change. The easiest way to explain the difference, though, is to first back up and discuss a rule that applies to couples in which both spouses are still alive.

Prior to reaching full retirement age, if you are eligible for your own retirement benefit and a spousal benefit, and you file for either of the two, you are automatically “deemed” to have filed for the other benefit as well. You have no choice in the matter.

After reaching full retirement age, however, deemed filing no longer applies. And that’s why the typical claiming strategies start at full retirement age rather than at age 62. For example, after reaching full retirement age, one spouse can file a restricted application for spousal benefits only while allowing his/her own retirement benefit to continue growing until age 70.

Deemed Filing Doesn’t Apply to Widow(er) Benefits

The deemed filing rule does not, however, apply to widow(er) benefits. As a result, there are two possible Social Security claiming strategies that often make sense for somebody whose spouse has passed away:

  1. At age 60, you could claim a widow(er) benefit while allowing your own retirement benefit to grow until 70.
  2. Or, you could claim your own retirement benefit at 62 while allowing your widow(er) benefit to grow until full retirement age.

There are exceptions of course, but it’s often advantageous to allow the larger benefit to continue growing until it maxes out (either at FRA or at age 70, depending upon which benefit it is) and to claim the other (smaller) benefit as early as possible.

Considering a Second Marriage?

Also of note: If you get remarried before age 60, you will (except in cases of disability) lose eligibility for widow(er) benefits based on your first spouse’s work record.

Of course, the usefulness of this information varies greatly depending on the age at which you find your new partner. If you’re only 50, waiting for 10 years is probably not the most palatable option. But if you’re 59 ½ and weighing the pros and cons of various wedding dates, it’s probably worth including Social Security in the discussion.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."
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