With an increasing number of people planning to work well into their 60s and beyond, it’s important to understand how the amount of money you earn in your later years can affect your Social Security (SS) benefits.
Working can reduce benefits
Eligibility to claim Social Security begins at age 62. However, claiming benefits before your Full Retirement Age (FRA) while also generating wage or self-employment income will trigger an “earnings test” that can reduce your SS income, depending on how much you earn. (The FRA is 66 for people born between 1943 and 1954. It then gradually increases in two-month increments until reaching 67 for people born in 1960 or later.)
If you claim benefits before your FRA, the Social Security Administration will ask if you plan to continue working, and if so, how much you expect to earn. If your FRA will be reached after 2015 and you are claiming benefits in 2015, you can earn up to $15,720 with no reduction in SS benefits. However, for every $2 you earn above that amount, $1 of benefits will be deducted. (The threshold increases each year.)
If your FRA will be reached in 2015, you can earn much more in the months leading up to the month when you attain your FRA — $41,880 — with no reduction in benefits. For every $3 earned above that, $1 of benefits will be deducted. Beginning in the month you reach your FRA, there are no SS benefit deductions no matter how much you earn.
The earnings test applies to wages and/or earnings from self-employment. Income that doesn’t count includes government benefits, investment earnings, pensions, money drawn from an IRA or 401(k), interest, annuities, and capital gains.
Some confusing nuances
If your benefits are reduced as a result of the earnings test, they won’t be reduced evenly throughout the year. Instead, the reductions will affect the first benefit checks of the year. For example, if your monthly benefit would have been $1,500 but the earnings test results in a $3,000 reduction for the year, you would receive no benefits for the first two months of the year.
The following year, when you file your income tax return, if your actual wage and self-employment income is higher than what you estimated, the Social Security Administration will send you a bill; if it was lower, the SSA will send you a check to cover the excess it deducted.
One commonly misunderstood aspect of the earnings test is that the amount of any benefits reduction may end up being recouped through a permanent benefit increase at your full retirement age.
For example, let’s say your FRA is 66 but you begin claiming benefits 48 months earlier at age 62. Let’s also say the earnings test resulted in a benefit reduction during those 48 months that amounted to 10 months’ worth of age 62 benefits. Beginning in the month that you attain your FRA, your monthly benefit will be permanently increased to the amount you would have been entitled to had you started claiming benefits at age 62 and 10 months. How much of the deducted benefits you end up recouping depends on how long you live.
Bottom line? If you’re between age 62 and your FRA and are still generating paid income, the earnings test is one more reason why it’s generally best to wait at least until reaching your FRA before claiming benefits.
Working can trigger taxes
It may not seem fair to pay into Social Security over the course of your career via a payroll tax only to potentially have to pay more taxes on some of the benefits you receive from those contributions. But that’s how it works if your retirement income exceeds certain “combined income” thresholds.
That term refers to the combination of one-half of your Social Security benefits, plus your adjusted gross income, plus any tax-exempt interest you received.
If you file as an individual with combined income of less than $25,000, you won’t have to pay income taxes on your Social Security benefits. Between $25,000 and $34,000, you may have to pay income taxes on up to half of your SS benefits. Make more than $34,000 and up to 85% of your benefits may be taxable.
If you are married, file a joint return, and you and your spouse have combined income of less than $32,000, none of your Social Security benefits will be taxable. Between $34,000 and $44,000, you may have to pay income taxes on up to half of your SS benefits. Make more than $44,000 and up to 85% of your benefits may be taxable.
Understanding how Social Security benefits are taxed can be an important determinant in choosing when to claim benefits and when to tap which retirement accounts for income. For example, if you have a tax-deferred retirement account (such as a traditional IRA or 401k) and a tax-free account (like a Roth IRA/401k), it may be best to tap the tax-deferred account before starting to claim Social Security. That assumes you'd be paying taxes on the retirement account money at a lower rate than you'll be in once you start taking SS benefits. In this scenario, you would hold off on tapping your tax-free account until after beginning to claim SS benefits.
As with many aspects of Social Security, figuring out how to maximize your benefits while minimizing your taxes can be a complex process. It may be beneficial to utilize one of the independent services available to help you determine your best claiming strategy (see related links in the sidebar) or to meet with a financial planner who has expertise in retirement income planning.