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Can a Year of Low Earnings Reduce My Social Security Benefit?

A reader writes in, asking:

“I’m in the not-quite-retired-but-probably-could-afford-to-if-I-wanted-to stage of my career. I am pondering many options, including cold-turkey retirement, switching to fewer days per week, or retiring but starting a new type of work that I hope would be more fun on a daily basis. One concern I have about the last two options is that they will result in one or more years of lower earnings at the end of my career, and I have heard that could reduce my social security retirement amount. Is that true?”

Short answer: no, that’s not true.

Many pensions are based on things like “average of last 5 years of earnings.” For pensions like that, yes, a year of low earnings at the end of one’s career could result in a smaller pension.

But that’s not how Social Security works. Your Social Security retirement benefit is based on your 35 highest years of earnings (after adjusting years prior to age 60 for wage inflation). If you have a new year of low earnings, worst-case scenario is that it isn’t one of your 35 highest and it therefore is simply not included in the calculation. In other words, that year of earnings wouldn’t reduce your benefit — it just wouldn’t increase it, as an additional year of high earnings might.

However, a year of low earnings could cause the benefit estimates on your Social Security statement to go down. Similarly, a year of low earnings could cause your actual benefit to be lower than the benefit estimate that you are seeing on your statement.

The key point here is that the benefit figures that appear on your statement are estimates. And those estimates include a projection about future earnings. Specifically, the estimates assume that you continue earning — at the same earnings level as your most recent earnings year for which the SSA has data — until you retire and file for benefits (the estimated figures on the statement assume that those two things will happen simultaneously*).

So:

  1. If you have a year of earnings that was lower than your prior year, once your benefit estimate reflects the new lower year of earnings (and therefore projects that lower earnings level forward) it could result in a lower estimate, and
  2. If your actual earnings turn out to be lower than the assumed/projected earnings baked into the estimated benefit figures, your actual benefit could turn out to be lower than the estimated benefit.

But again, an additional year of low earnings will not reduce your actual benefit. Worst-case scenario is that a year of low earnings will have no effect on your actual benefit (i.e., will not increase it).

*This article explains how to use the SSA’s calculators to calculate what your benefit would be if you retire at a different age than the age at which you file for benefits.

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

Social Security cover 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."

The Effect of Taxes on the Social Security Filing Decision

A reader writes in, asking:

“Could you write something explaining the effects of taxes on the age you decide to begin Social Security. Especially since RMD’s may be delayed to age 72 under new legislation. Also, my state doesn’t tax Soc. Sec. benefits. Thanks.”

In most cases I have looked at, tax planning has worked out to be a point in favor of delaying.

The mechanism at work is that Social Security is, at most, 85% taxable. In contrast, distributions from tax-deferred accounts are usually fully taxable. And spending down your tax-deferred accounts in order to delay Social Security has the effect of increasing the portion of your lifetime income that is made up of (not-fully-taxable) Social Security and decreasing the portion of your lifetime income that is made up of (usually-fully-taxable) distributions.

And a similar thing is usually going on at the state income tax level. Only 13 states tax Social Security benefits, whereas a majority of states treat distributions from tax-deferred accounts as taxable income.

But, to be clear, the effect of taxes on the Social Security decision is very case-by-case. While the above effect is pretty broadly applicable, there could be any number of other factors that could point in the other direction. Almost anything that appears on a person’s 1040 could end up being a relevant factor in the analysis.

Ideally, the way to do the analysis (e.g., when comparing two possible claiming strategies) is to:

  1. Use tax prep software (or other similarly fully featured tax planning software) to estimate the total household tax bill year-by-year under each claiming strategy that you want to test. (For a married couple, you actually want to estimate 3 different tax costs for each year for each claiming strategy: a scenario in which both people are alive, one in which only Spouse A is alive, and one in which only Spouse B is alive.)
  2. Do a typical net present value calculation for each strategy, including the differences in tax costs as cash flows. For example, if you are comparing two strategies, and Strategy 2 has higher taxes by $1,000 in a given year, include that as a $1,000 negative cash flow for Strategy 2 that year. (Again, for a married couple, you would be doing three calculations for each year for each strategy — both spouses alive, only A alive, only B alive — then weighting each one by its probability, using a mortality table of your choosing.)

With regard to step #1, I would caution against using a spreadsheet or other similar DIY tax calculation. It’s very easy to accidentally fail to include a given credit/deduction/exclusion that would affect the analysis — especially when we consider state income taxes as well.

And of course it’s important to remember that all of this is just a projection. There are many unknowable factors involved.

Tangential note: my spreadsheet for doing step #2 of this analysis is what originally served as the starting point for the Open Social Security calculator. And it’s part of why I was surprised to realize that most (all?) other Social Security claiming calculators use a fixed life expectancy assumption in the calculation (i.e., assuming with 100% certainty that a person dies on a given date). Doing so is fine for an unmarried person, but for a married couple it significantly underestimates the length of time for which only one spouse will be alive. That really messes with the value of survivor and spousal benefits, and it also really messes up the expected tax cost calculation (because taxes change significantly once one spouse dies).

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

Social Security cover 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 Important is Social Security Planning?

A reader writes in, asking:

“Just how important is it to learn about all the ins and outs of social security? When I look at the benefit estimates on my statement, they aren’t exactly small amounts, but this doesn’t look like it’s going to be the most important financial decision I’ve made in my life. And yet people go back and forth forever (eg on bogleheads) about whether filing at 62, 66, 70, or whatever is best.”

In terms of expected spending (in today’s dollars) over the course of a retirement, the difference between the ideal Social Security filing strategy and a very bad strategy is often in the $20,000-$40,000 range for a single person. For a married couple, the difference between the ideal strategy and a very bad strategy would often be in the $50,000-$100,000 range.*

The difference between the ideal strategy and a fairly similar strategy is much smaller. For instance if filing at 70 is ideal for you, filing at 69 and 6 months is likely to have a very similar result — a few thousand dollar difference over the course of your retirement.

So even if we’re comparing a good strategy to a very bad strategy, no, it’s not even close to the most important financial decision you’ll ever make. The career you pick, the city/cities you choose to live in, the home(s) you buy or don’t buy, the job(s) you take, whether you get married/divorced/have kids — all of those things will have a larger impact on your finances over your lifetime than your Social Security claiming decision(s).

But, for most people, you can learn most of what you need to know about Social Security from just a handful of hours of reading (in addition to my book Social Security Made Simple, I can also enthusiastically recommend Andy Landis’s Social Security: The Inside Story or Jim Blankenship’s Social Security Owner’s Manual). And if a few hours of self-education can provide a mid-five-figure expected return, those are some well-spent hours.

A key point here is that if you are not a financial planner (i.e., you are not trying to become an expert in all of the situations your clients might face), you only need to learn about the parts that apply to you. You can (probably) ignore most of the complexity. For example:

  • If you don’t have minor children or adult disabled children, you can ignore everything about child benefits and the family maximum.
  • If you don’t have a pension from non-covered employment, you can ignore everything about the windfall elimination provision and government pension offset.
  • If you have never married (or if you were married less than 10 years prior to a divorce), you can ignore everything about spousal/survivor benefits.
  • If you are married and you and your spouse were both born after 1/1/1954, you can ignore everything about restricted applications.

Most unmarried people and married couples have either one or zero complicating factors. A basic cookie-cutter-type plan works reasonably well for most people.

Social Security planning is primarily about avoiding a particularly bad strategy, and that mostly means:

  • Don’t miss a restricted application if you have the chance.
  • Get within a year or so of your ideal filing age. (For example if age 70 is the mathematically ideal age for your circumstances, don’t file at 62 or 63. But don’t worry too much about the difference between 69 and 70.)

*The differences are often greater when we also account for tax planning. Also, delaying has a risk-reduction effect that isn’t reflected in these numerical differences.

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

Social Security cover 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: It Is an Asset, But Not a Bond

A reader writes in, asking:

“At our local Bogleheads chapter meeting, there was a heated discussion about Social Security, specifically, whether it should be counted as a bond in your asset allocation. My view is that it’s not really an asset because you can’t sell it. But one of the more experienced people in our group was emphatic that it’s a mistake to leave Social Security out of an asset allocation analysis and that it should be counted as a bond because it provides predictable payments.”

This question comes up over and over, year after year — both in my email inbox as well as on the Bogleheads forum.

Social Security is an asset. It’s true that it is not a liquid asset (i.e., you cannot sell it). But even illiquid assets show up on balance sheets. Same goes for lifetime annuities. They are assets, even if they are not liquid.

And yes, Social Security is a fixed-income asset. So it’s more bond-like than stock-like.

But it’s definitely not a bond.

There are a lot of differences between a) having a $2,000 monthly Social Security benefit at full retirement age (i.e., a stream of income with a present value of about $350,000) and b) having $350,000 of bonds in your brokerage account.

Social Security is what it is — and it isn’t what it isn’t.

The desire to classify everything as either a stock or a bond is completely bananas.

For example, do you classify your house as a stock, because its value goes up and down considerably over time? Or do you classify it as a bond, because it pays you “interest” in the sense that you do not have to pay rent each month? (I hope the answer is obvious: it’s neither a stock nor a bond, because it is a house.)

The distinctions between different types of assets are real and useful.

Social Security:

  • Is inflation-adjusted,
  • Will last your entire lifetime,
  • Will not extend beyond your lifetime (or beyond you and your spouse’s lifetimes if married, child benefits notwithstanding),
  • Is absolutely illiquid (i.e., it’s not just hard to sell; it cannot be sold at all), and
  • Is subject to political risk.

By shoehorning that into the “bond” category, you are ignoring some or all of those unique characteristics. You are ignoring useful information.

Relatedly, if you have decided, for example, that you want 40% of your portfolio in bonds, but you haven’t yet decided what will count as a bond, how did you decide that 40% was the right number? Perhaps the line of reasoning that went into that decision had some flaws.

Rather than counting Social Security income as part of your bond allocation, I’d suggest using this method for fitting it into your overall retirement plan:

  1. Determine how much money you plan to spend each year during retirement.
  2. From that, subtract any part-time job or business income you expect to earn.
  3. From the remaining amount, subtract your Social Security/pension income to determine how much you will need to spend from your portfolio each year.
  4. Then make any portfolio-related decisions (including asset allocation) with that net required-spending-from-portfolio figure in mind.

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

Social Security cover 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 with Foreign Work History: Totalization Agreements

Last week I was a guest on Rick Ferri’s Bogleheads on Investing podcast. You can listen to that podcast here. (The Bogleheads discussion thread is here, if you want to post any comments.)

One question that a few Bogleheads had asked was about how a US citizen can qualify for U.S. Social Security benefits if they were covered under a foreign social security system for a portion of their working career.

I gave a very brief answer on the podcast, but I wanted to discuss that topic more thoroughly here.

In short, how exactly it plays out depends on which other country you worked in. The U.S. has “totalization agreements” with many countries that provide the rules for how a worker will be treated, but the exact details vary from one agreement to another. (There’s no way around such a situation, given that each country has its own unique tax and social security systems.)

And, unfortunately, given that the specifics vary for each of the agreements, it’s unlikely that you’ll find anybody who is a true expert on any one of them. (I most definitely am not. Despite dealing with Social Security topics all the time, it would be rare for me to get even two people asking about the same totalization agreement in a given year.)

Generally speaking, however, the effects of the totalization agreements are to:

  1. Eliminate dual taxation that would otherwise occur (i.e., simultaneously paying into two countries’ social security systems), and
  2. Allow you to qualify for benefits when you might not otherwise qualify.

Qualifying for Benefits (“Totalization”)

If you meet all the basic requirements under one country’s system, you will get a regular benefit from that country.

If you have at least 6 credits (“quarters of coverage”) under the U.S. Social Security system, but you do not have the 40 credits that would ordinarily be necessary to qualify for a retirement benefit, your credits will be “totalized.” That is, your credits under the foreign social security system will be counted toward qualifying for U.S. Social Security.

And the opposite would happen as well — if you don’t quite qualify for coverage under the foreign social security system, totalization would allow your U.S. periods of coverage to be counted toward qualifying there.

Calculating Benefits

If you end up qualifying for U.S. Social Security benefits via totalization, there is a special set of rules for calculating the benefit. You can find the exact details here, but very roughly what’s going on is that:

  • Only your U.S. earnings are included in the calculation, and
  • The benefit that is calculated based on those U.S. earnings is ultimately multiplied by a fraction, which represents the portion of your career for which you were paying into the U.S. system.

Windfall Elimination Provision and Government Pension Offset

Usually, when you receive a pension from employment for which you did not pay U.S. Social Security taxes, the windfall elimination provision (WEP) applies, reducing your primary insurance amount. With regard to foreign social security benefits, however, the WEP will not apply if you are:

  • Entitled to a U.S. totalization benefit (i.e. you only qualified for a U.S. Social Security benefit by counting your credits from the foreign social security system), or
  • Entitled to a regular U.S. benefit, as well as a foreign benefit which is based on a totalization agreement with the U.S. (i.e. you only qualified for the foreign social security benefit via counting your U.S. credits), and you are not receiving any other pension based on non-covered work (e.g., a pension from the state of Illinois).

Finally, a foreign social security benefit will not trigger the government pension offset (GPO).

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

Social Security cover 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."

Can You Trust Information from the SSA?

A reader writes in, asking:

“I’ve heard from a few different acquaintances that they received bad information or advice from the SSA. Is it really true that you can’t even trust information coming directly from the Social Security Administration?”

It’s true that SSA employees sometimes provide inaccurate information. SSA representatives are dealing with a complex set of rules regarding a broad range of topics. And they only get a limited amount of training before being put on the front line, answering people’s questions. Mistakes happen, despite best efforts and good intentions.

It’s also important to recognize that Social Security rules use very specific terminology. I have encountered many situations in which an SSA employee provided an answer that was 100% correct — but the person asking the question misunderstood the answer. I’ve also encountered numerous situations in which a person accidentally asks something other than what they meant to ask (e.g., they ask whether they are entitled to a benefit, when they really wanted to know whether they’re eligible for that benefit), and the SSA employee correctly answers the question asked. And, again, the net result is that the person comes away with a misunderstanding, even though the SSA employee provided a correct answer to the question that was asked.

The key takeaway here is that, if you want to be truly sure of something, you have to look at the official rules. I know that stinks, because they can be challenging to read. But before relying on something somebody tells you (whether that somebody is an SSA employee, me, or anybody else), try to find confirmation from an official source. Here are the three official sources to check, in order of authority (from highest to lowest):

A few points about the above sources:

  1. The Regulations have not been updated for the changes made by the Bipartisan Budget Budget Act of 2015. (If you need information relating to deemed filing or voluntary suspension, I would go to the POMS.)
  2. The POMS is by far the most thorough of the sources above. It does not, however, have any legal authority. So if, for example, something in the POMS contradicts something in the Act, the Act wins.
  3. Other than the three above sources, most pages on the SSA website are akin to IRS publications in that they’re intended to be plain-english explanations of the rules, but they may use imprecise language or omit exceptions that could be relevant to you.

Finally, let me offer two related tips about dealing with the SSA:

  1. Remember that SSA employees are not financial planners. They are not really trained for giving advice, because that’s not their job. Rather, they are essentially “order takers” whose job is to process the application that you file and to answer questions about what benefits you are/aren’t entitled to (or eligible for).
  2. When you apply for Social Security, apply online. In all the time I’ve been working with Social Security, I’ve only ever heard from one person whose online application was processed incorrectly. Conversely, I have heard from I have-no-idea-how-many people about their in-person or phone applications being processed incorrectly.

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

Social Security cover 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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My new Social Security calculator: Open Social Security