Archives for August 2012

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Is There a Best Age to Claim Social Security?

Social Security is sometimes described as “actuarially neutral,” meaning that, at a program-wide level, the government should be indifferent to whether people claim earlier or later, because the reduction in monthly benefits that results when people claim early should be approximately offset by the fact that those people are collecting for a greater number of months.

But from the perspective of an individual person, the decision of when to claim Social Security is only neutral under a very specific set of circumstances. Much more often, there is a compelling reason to claim either earlier or later, depending on circumstances. (The most obvious example: You’re 62, and you absolutely need the money right now.)

Social Security’s Built-in Interest Rate

Consider an unmarried person, age 62, trying to decide whether to take benefits right away and invest them or wait until age 70 to claim benefits. If this person lives until exactly the average life expectancy for somebody already age 62 (i.e., 82.9 years, according to this table from the Social Security Administration), the break-even inflation-adjusted rate of return would be approximately 2%.

In other words, if this person were to live to just shy of 83 years, she would have been better off taking benefits at age 62 if she could get an inflation-adjusted return better than 2%, and she’d have been better off waiting until age 70 if she didn’t think a 2% inflation-adjusted rate of return was sufficiently likely.

Given current interest rates (with TIPS yields negative all the way up to 20-year maturities), 2% after inflation is a heck of a lot better than you can do from safe investments. And that makes delaying Social Security more attractive than it would be in a time when interest rates are high.

What’s Your Life Expectancy?

The life expectancy figure I mentioned above is an average of both men and women. For men, the actual figure is 81.4 years. For women, it’s 84.3 years. As a result, it’s generally more advantageous for unmarried women to delay Social Security benefits than for unmarried men to do so (because women who hold off on taking Social Security will, on average, receive their increased benefits for a greater number of months than men who hold off on claiming will).

And if you have any other reasons to think you have a life expectancy that’s meaningfully shorter or longer than average (e.g., a medical condition on the one hand or a family history of people living into their 90s on the other hand), that should affect your decision as well. The longer you expect to live, the better it is to delay Social Security.

Are You Married?

Consider Allan and Liz, married, both age 62. Because Liz spent many years out of the paid workforce to raise their children, Liz has a significantly lower earnings history than Allan. (And, therefore, Allan’s own retirement benefit is significantly greater than Liz’s.)

After either Allan or Liz dies, the surviving spouse will be receiving an amount equal to Allan’s benefit. (If Liz is the surviving spouse, it will be in the form of a widow’s benefit.)

As a result, if Allan chooses to hold off on claiming his own retirement benefit, he increases not only his own benefit while he’s alive, but also Liz’s widow’s benefit in the event that he predeceases her.

In contrast, if Liz holds off on claiming Social Security, the amount the couple receives is only increased during the period of time that they’re both alive.

Takeaway: It often makes sense for the higher-earning spouse to delay claiming his/her own benefit as long as possible, and for the lower-earning spouse to take his/her benefit at an earlier point.

Bonus tip: When the higher-earning spouse reaches full retirement age, if the lower-earning spouse has started taking his/her benefit already, the higher earning spouse can file a restricted application to claim only spousal benefits. This allows the higher earning spouse to at least receive something for a few years, while allowing his/her own benefit to continue growing until age 70.

In short, while Social Security may be “actuarially neutral” at a program level, most real-life people do stand to gain something by taking the time to consider whether claiming early, late, or somewhere in the middle is the best for their own particular circumstances.

Editorial note: Just last night I came across a paper (shared by BobK on the Bogleheads forum) that takes a more academic look at this same topic. The authors (John B. Shoven and Sita Nataraj Slavov) reached very similar conclusions. Also, if you’d like to check my math regarding the 2% inflation-adjusted return figure I quoted above, here’s the spreadsheet I used.

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Which Funds to Take RMDs From

A reader writes in, asking:

“I have begun taking Required Minimum Distribution from my IRA. Does it make any difference which funds I draw from? For example, should I draw equally across all investments to total the RMD for the year? Or should I first draw all of the capital gains and dividend distributions from each fund, and then complete the RMD by taking an equal amount from each fund? I understand the IRS doesn’t care, since they are only looking at the total amount coming from the IRA, not from which funds the RMD is taken.”

You’re right that the IRS doesn’t care which fund(s) the RMD comes from. Nor do they care whether the RMD comes from capital gains distributions, dividend distributions, or originally-invested capital. So the questions to answer when deciding how to take the RMD are simply:

  1. What asset allocation do you want to have after taking the RMD, and
  2. How should the RMD be taken so as to get you there?

In other words, taking an RMD can be approached like any other rebalancing.

How about an example?

Joe is 75 years old. As of the end of last year, Joe’s IRA balance was $395,000. Using an RMD calculator, we can see that his RMD for this year would be $17,249 (which we’ll round to $17,250 for simplicity’s sake). Today, Joe’s portfolio looks like this:

In his $100,000 taxable brokerage account:

  • $55,000 in Vanguard Total Stock Market Index Fund,
  • $45,000 in Vanguard Total International Stock Index Fund.

In his $400,000 traditional IRA:

  • $275,000 Vanguard Total Bond Market Index Fund,
  • $80,000 Vanguard Total Stock Market Index Fund, and
  • $45,000 Vanguard Total International Stock Index Fund.

Joe wants his overall asset allocation to be 50% bonds, 35% U.S. stocks, 15% international stocks. (As we’ve discussed previously, it’s the overall asset allocation for the portfolio that’s important, not the allocation of any individual account.)

If Joe decides to take his $17,250 RMD today (and we assume that he needs to spend the money for living expenses), that leaves a total portfolio value of $482,750. ($500,000 – $17,250.) And given his desired allocation, he wants to have the following amounts:

  • $241,375 in bonds ($482,750 x 50%),
  • $168,963 in US stocks ($482,750 x 35%), and
  • $72,412 in international stocks ($482,750 x 15%).

Given his taxable holdings (which we’ll assume we don’t want to disturb for the moment, so as to avoid incurring any taxable capital gains), that means his IRA needs:

  • $241,375 in bonds (because there are none in the taxable account),
  • $113,963 in US stocks ($168,963 desired total, minus the $55,000 already held in the taxable account), and
  • $27,412 in international stocks ($72,412 desired total, minus the $45,000 already held in the taxable account).

In other words, his RMD should come from the bond fund (in which he has $275,000 despite only wanting $241,375). And if Joe wants to finish rebalancing his portfolio, he should sell more of the bond fund and some of the international stock fund to get them back down to their intended allocations, while buying US stocks to get that part of the portfolio back up to its desired allocation.

In the event that Joe doesn’t need to spend the money, his RMD won’t actually reduce his total portfolio size. Rather, it will simply shift of some of the money from the IRA to the taxable account. But the overall approach would be the same:

  1. Determine the desired amount (in dollars) of each holding, then
  2. Make the necessary changes to get to that allocation (hopefully without selling anything in the taxable account).

Roth IRA Contributions for Expatriates

A reader writes in, asking:

“I am an expat teacher and am confused about whether or not I can contribute to a Roth IRA. I’d like my retirement savings to include a Roth IRA component if possible. Under what conditions can an expat contribute to a Roth?”

I enjoyed this question because it relates to two topics we’ve discussed recently: the definition of compensation income for IRA purposes (which we discussed when talking about contributing to an IRA in retirement) and the varied definitions of modified adjusted gross income, which we discussed on Monday.

Roth IRA Contribution Requirements

In order to contribute to a Roth IRA:

  • You need “compensation income” at least equal to the amount of your contribution, and
  • Your modified adjusted gross income must be below a certain limit.

With regard to the first requirement, if you’re married filing jointly, you do not personally need to have compensation income, so long as the combined compensation income of you and your spouse is at least equal to your combined IRA contributions.

What’s Included in Compensation Income?

Per Internal Revenue Code section 219 (and as explained in IRS Publication 590), any amounts that you exclude from your income are not included in compensation income. This is particularly important for expats because it means that any income you exclude via the foreign earned income exclusion (or foreign housing exclusion) does not qualify as compensation income.

Therefore, in order to contribute to a Roth IRA, you would need to choose not to claim the exclusion, have a source of compensation income that doesn’t qualify for the exclusion, or have foreign earned income that exceeds the maximum exclusion.

Modified Adjusted Gross Income

As far as the second requirement (the income limit), modified adjusted gross income for these purposes requires that you start with your adjusted gross income and add back (among other things) amounts you subtracted for the foreign earned income exclusion and the foreign housing exclusion or deduction.

In other words, income excluded via the foreign earned income exclusion does not count when you do want it to (when determining compensation) and does count when you don’t want it to (when determining modified adjusted gross income to see if you’re below the applicable limit).

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