March 2002

Choosing the Right Beginning Age for Social Security Benefits

By Neal R. VanZante

The Senior Citizens' Freedom to Work Act (SCFWA) of 2000 repealed the Social Security earnings test for individuals between normal retirement age (currently age 65) and age 70. The earnings test for individuals that elect early retirement (currently age 62) was not affected.

Prior to SCFWA, individuals that continued to work after beginning to receive Social Security benefits at age 65 would have their benefits reduced by $1 for each $3 of earnings exceeding an earnings limit ($17,000 in 2000). Individuals that continued to work after their normal retirement age were advised to defer Social Security benefits until they retire or reach age 70, especially since their benefits would increase due to delayed retirement credits (currently 6% per year). Since SCFWA, many financial advisors strongly recommend beginning to receive Social Security benefits at the normal retirement age, or earlier.

Review of Recent Literature

Robert Hey wastes no time informing readers of "Benefit Puzzle: Take the Money at 65, or Wait?" (AARP Bulletin, November 2000) that "many financial advisors have no trouble making a strong recommendation: Take the money now." Hey explains that individuals that wait until age 70 to begin receiving benefits must live until age 86 to recoup the benefits they lose between 65 and 70. Hey briefly mentions that an individual's tax situation could affect the decision, but says that it is possible to come out ahead by waiting until age 70 to begin taking benefits only if the person lives a "very long life."

Humberto Cruz ("Age Weighs Heavy on Social Security Benefits," Corpus Christi Caller-Times, November 6, 2000) takes a slightly more cautious approach, but suggests that age 62 is probably the better time to begin receiving benefits. The article points out that retirees that do not need the money and plan to invest it may benefit more by taking early benefits.

The article concludes that "if those investments can achieve an 8% rate of return-the historical average for a balanced portfolio of stocks and bonds-you would have to live to age 83 to make it worthwhile to wait to collect benefits until full retirement age, and you would have to live beyond age 95 to justify waiting until age 70 for the higher delayed benefits." Sidney J. Baxendale, in "Social Security Benefit Delayed is Generally Wealth Denied" (Practical Tax Strategies, October 2000), provides results obtained from an elaborate computer model. The model assumed that all Social Security benefits would be invested, that taxpayers would remain in the same tax bracket, that taxpayers would have sufficient income to cause 85% of the Social Security benefits to be taxed as received throughout the entire analysis, and that the cost-of-living adjustment would be 2% annually. Baxendale then compared accumulated amounts using assumed rates of return ranging from 6% to 12% and different assumptions about the taxability of the investments. Baxendale points out that the benefit of taking early benefits diminishes at lower rates of return, but concludes that the decision is clear. A "Planning Tip" panel clearly states: "Taxpayers who work past age 65 are generally better off starting to collect Social Security benefits at that age … even if they do not need the extra current income. Although delaying the benefit start date results in larger monthly checks, the recipients would have to enjoy extreme longevity to recoup the renounced benefits, plus investment income they could earn."

What's Wrong with this Picture?

To understand the above advice, one must first understand the assumptions made about the various factors that affect the decision as to when to begin receiving Social Security benefits. One factor is what will be done with the benefits as they are received. The Baxendale model assumes that the money will be invested toward the goal of accumulating the maximum wealth at death. Another factor is the tax consequences on investment earnings. As Baxendale points out, if any of the investment earnings are taxed, the benefit of earlier distributions is reduced.

A major decision factor is the assumed rate of return on the investment. Most of the models assume very high rates of return, based on the historical returns of a balanced stock portfolio. This assumption is highly questionable for older individuals, who would have shorter investment horizons and presumably be more risk-averse. Another major factor is the income tax consequences. As in the Baxendale model, many assume that the tax rates remain the same throughout the analysis or that there is no tax on the Social Security benefits. This is probably unrealistic in most cases. Social Security benefits will probably be taxed for individuals working between 65 and 70, although it is possible to avoid taxes after actual retirement. For most individuals, the models likely overstate the accumulated benefit of earlier receipts.

Another underlying assumption is that it is rare for individuals to reach an age old enough to benefit from waiting until age 70. According to IRS, the average 65 year old can expect to live slightly past age 85. The American Savings Education Council's (ASEC) online worksheet assumes individuals will reach age 87.

A Simpler, More Realistic Model

To simplify the decision model, it is possible to eliminate factors that are not relevant. For example, if it is assumed that there are no differences in the taxation of Social Security benefits throughout the analysis, then taxes can be ignored altogether. There is no need to build in an assumed cost-of-living adjustment because the Social Security Administration adjusts all benefits annually. An inflation-adjusted rate of return can be used instead (the Social Security model assumes a 3% inflation-adjusted rate of return). Separate calculations of the beginning amounts at various ages are not necessary if an inflation-adjusted rate of return is used.

The author developed a simplified model using assumed inflation-adjusted rates of return from 2% to 8% and various assumptions about taxation of Social Security benefits. The model was applied to individuals born between 1943 and 1954. For these individuals, the normal retirement age is 66. Benefits received at age 62 (early retirement) are 75% of those received at age 66. Benefits received at age 70 (delayed retirement) are 132% of those received at age 66.

Under this scenario, the assumed inflation adjusted rate of return has a huge effect. At an assumed rate of 2%, for example, an individual who lives past 80 is better off waiting until they are 66 to begin receiving Social Security benefits. An individual who lives past 85 is better off waiting until age 70. At an assumed rate of 5%, these ages increase to approximately 88 and 93 (for beginning benefits at 66 and 70, respectively). And, at 6% or higher, it does not pay to wait until age 70 unless the individual lives well past 100. Using the Social Security Administration's assumed inflation-adjusted rate of 3%, the ages are 82 and 87 (for beginning benefits at 66 and 70, respectively).

Assuming that 85% of the Social Security benefits are taxed at a rate of 28% from age 62 through 65, the advantage of early benefits is diminished, meaning that an individual does not need to live as long to benefit from postponing beginning of benefits until age 66. This could be the case if an individual continues to work until age 66 and if the earnings test were repealed at some future date. (If the earnings test is not repealed, collecting Social Security benefits at age 62 just is not feasible for most individuals that continue to work.) Assuming that 85% of Social Security benefits are taxed at a rate of 28% through age 69, for an individual who has planned for retirement to avoid taxation of the Social Security benefit, the assumed rate of return again plays a major role. This could easily be the case if an individual continues to work until age 70 and then retires to avoid taxation of Social Security benefits. At an assumed rate of 2%, an individual only needs to live until about age 81 to be better off waiting until age 70 to begin receiving benefits. Even at 6%, one only needs to live to about age 87, the age assumed by the Social Security Administration.

Different assumptions about tax rates would of course yield different results. If we assumed a 15% tax rate on only 50% of the Social Security benefits before retirement, for example, then the break-even age would increase. If a higher tax rate is assumed, the break-even age would decrease. There is really no one-size-fits-all model.

All break-even ages would be lower if any of the investment earnings were taxable. Given that older individuals tend to invest more conservatively, assuming even lower break-even ages appears reasonable. An additional factor ignored until now is state income taxes. Many states (and municipalities) use the federal income tax return as the basis for collecting income taxes. For individuals in states that tax Social Security benefits, the break-even age would be even lower.

Another factor that married couples should carefully consider is the "spousal benefit." The author has been advised by the Social Security Administration that the spousal benefit is based on benefits actually being received: "If you receive credit for delaying your benefits, the spousal amount will be based on that higher amount" (July 31, 2001, e-mail from SSA).

Other Considerations

The above model, as well as many others, assumes a goal of wealth maximization at death. But what if an individual's goal is to live as well as they can during their lifetime and die with zero in the bank? Does this change their strategy? What about individuals who will live entirely on Social Security benefits? Postponing their benefits as long as possible makes great sense. By working or using other retirement benefits until age 70, these individuals might be in a position to live out their lives on their increased Social Security benefits. Certain individuals may wish to begin their Social Security benefits at the earliest possible age because they have reason to believe they will die before they reach 70.

The biggest fear of the majority of retirees is that they will outlive their retirement benefits. This fear will probably increase as people live longer. For these individuals, postponing the start of their Social Security benefits to age 70 makes sense. This strategy will provide the largest amount of inflation-adjusted continuing benefits as long as they live.

A Personal Decision

The decision of when to begin receiving Social Security benefits is a highly personal one. For most individuals, beginning benefits at age 62 is probably not a good idea. Unless the individual greatly limits their earned income, their benefits will be reduced even further and at least partially taxed. The reduced benefit is permanent and also permanently reduces the spousal benefit. If wealth maximization upon death is paramount, an individual may want to consider increasing life insurance coverage. Most individuals will probably do well to anticipate living a long time and postpone Social Security benefits until age 70 if possible. These individuals should arrange their financial affairs to reduce the possibility of their benefits being taxed after retirement.

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