Deciding Whether to Work While Collecting Social Security
Earned Income Can Reduce Early Retirement Benefits

By Thomas M Dalton and Diane D. Pattison

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Many individuals look to their CPAs for guidance on this question. Although the answer may at first appear to be obvious—as much as $1 of Social Security benefits will be lost for every $2 earned over the allowable threshold—a closer examination reveals that the answer depends on a beneficiary’s personal situation. A CPA must understand how the Social Security Administration generally calculates benefits when a retiree continues working. A CPA must also be able to make a judgment call as to whether this calculation will have a material effect on an individual’s financial situation, and, if so, whether the overall effect will be beneficial or detrimental.

A person must make two primary decisions about receiving Social Security benefits. First, should one start receiving benefits before reaching the full retirement age? Second, if benefits are started early, should one continue working? This article examines the factors that need to be weighed in making the second decision.

How Age at Retirement Affects Benefits

Social Security benefits are reduced when a person begins collecting benefits before full retirement age, whether working or not. Full retirement age depends on when a person was born. Exhibit 1 presents full retirement ages based on the year of birth. For example, a person born on March 2, 1943, has reached full retirement age when he or she has reached the age of 66 years and zero months.

When a person elects to collect Social Security benefits before full retirement age, the person’s normal retirement benefits (also called the Primary Insurance Amount, or PIA) are reduced. The reduction is equal to 5/9 of one percent, multiplied by the first 36 months before full retirement age and by 5/12 of one percent for each additional month before full retirement age. For example, if Joe, born March 2, 1953 (full retirement age 66 and zero months), elects to begin receiving benefits at age 62 (48 months before full retirement age), then Joe’s retirement benefits will be reduced by 25% [5/9 of 1% for 36 months, plus 5/12 of 1% for 12 months]. (See www.ssa.gov/retire2/agereduction.htm.) When a person elects to receive early benefits, the benefits continue at the lower amount, even after the beneficiary reaches full retirement age.

For example, note that, under Social Security rules, a person can begin collecting Social Security early in the first month that she is 62 for the entire month. Also note that a person is considered to turn 62 on the day before her birthday. Therefore, people whose 62nd birthday falls on the first or second day of the month can begin collecting Social Security in the month they turn 62. All other persons can begin collecting Social Security when they turn 62 years and one month. This means that some people can collect early benefits up to 48 months before full retirement age, and others only up to 47 months. Furthermore, people born on January 1 are considered to have been born in the prior year.

How Earned Income in Early Retirement Affects Benefits

Social Security benefits are further reduced when a person younger than full retirement age earns more than a minimal (or exempt) amount of income. Social Security benefits are intended to partially replace earnings in “retirement.” Under this logic, retirees collecting Social Security benefits historically have forfeited all or part of their benefits during years in which they are not fully retired. “Not fully retired” is currently defined within the context of Social Security as when a person has—

• not reached full Social Security retirement age, and
• earns more than the exempt amount of income.

The amount of exempt income that can be earned annually before triggering this second reduction in benefits is determined by two factors: the year the earnings occurred, and the age of the beneficiary.

The annual exempt amount of income varies each year according to increases in the national earnings level. Exhibit 2 shows the annual exempt amount of income for 2000 through 2008. The beneficiary’s age determines what column in Exhibit 2 is relevant. Beneficiaries reaching full retirement age during the calendar year have a higher threshold than beneficiaries who have not reached full retirement age during the calendar year. For example, a person born March 2, 1943, will reach full retirement age in March 2009 (66 years, 0 months). If this person is collecting early Social Security benefits in 2008, he or she can earn up to $13,560 before his or her Social Security benefits are reduced. A person born September 2, 1942, will reach full retirement age in July 2008 (65 years, 10 months). If collecting early Social Security benefits in 2008, this person may earn up to $36,120 during January through June, before Social Security benefits are reduced. All amounts earned after June 2008 would be exempt.

The excess earnings reduction is $1 of Social Security benefits for every $2 of earnings over the lower threshold for people who are not yet in the year they reach full retirement age. In the year a person reaches full retirement age, the excess earnings reduction is $1 of Social Security benefits for every $3 of earnings over the higher threshold. During the month of reaching full retirement age and thereafter, beneficiaries can earn an unlimited amount without a reduction in their Social Security benefits.

For example, assume that Jerry, born March 2, 1943, is collecting early Social Security benefits in 2008. He will not reach full retirement age until March 2009. Jerry earns $14,600 in 2008. The Social Security Administration will reduce Jerry’s annual Social Security benefits by $520 [($14,600 -- $13,560) ÷ 2]. It appears that Jerry pays a 50% excess earnings “tax” (i.e., a two-for-one reduction) on his wages in excess of $13,560—in addition to federal, state, and employment taxes (assuming his Social Security benefits are nontaxable, so there is no tax benefit when this income is reduced). This represents $43.33 in lost benefits each month.

Assume that Joan, born September 2, 1942, is also collecting early Social Security benefits in 2008. Further assume that Joan earns $41,520 in 2008 in the months before she attains full retirement age in July. Because Joan reaches full retirement in 2008, the Social Security Administration will reduce Joan’s annual Social Security benefits by $1,800 [($41,520 -- $36,120) ÷ 3]. It appears that Joan pays a 33% excess earnings “tax” (a three-for-one reduction) on her wages that are in excess of $36,120—in addition to federal, state, and employment taxes. This represents $150 in lost benefits each month. After June 2008, Joan can earn an unlimited amount of income without a reduction in benefits.

Given the high effective tax rate on earnings in excess of the 2008 threshold amounts, Jerry and Joan might choose to spend 2008 playing golf rather than earning wages. An additional disincentive for exceeding the earnings threshold amounts is the uncertainty that is always present when dealing with a governmental agency as large as the Social Security Administration. Seniors are generally fearful that any event changing their current Social Security benefits might trigger errors that will take months to correct. Retired people on a fixed income usually cannot afford these errors and will avoid actions that might cause them (such as exceeding the excess earnings threshold).

The Payback

The government is not without a sense of fair play. Seniors who lose Social Security benefits because they exceed the excess earnings thresholds are at least partially compensated when they reach full retirement age. The Social Security Administration recomputes the recipient’s monthly benefit, taking into consideration the months the recipient lost benefits because of excess earned income. In effect, the recomputation pretends that the recipient did not elect early retirement during the months when Social Security benefits were reduced or eliminated. The early retirement reduction of 5/9 (or 5/12) of 1% is removed for each of those months. The recomputed benefit becomes the recipient’s new monthly benefit, beginning at full retirement age.

For example, assume that Jenny (full retirement 66 years, 0 months) elected to begin receiving Social Security benefits at age 62 years, 0 months. If Jenny’s normal monthly benefit (PIA) at age 66 is $2,267, Jenny will receive only $1,700 per month at age 62 (75% of $2,267). This first reduction is because she began receiving benefits 48 months before her full retirement age. However, if Jenny continues working for 12 months after she begins receiving Social Security benefits—and if she earns enough during this time to reduce or eliminate 12 months of benefits—her monthly benefit amount will be recalculated when she reaches full retirement age at 66 and will equal approximately $1,814. Instead of a reduction in normal benefits of 25% [5/9 of 1% for 36 months, plus 5/12 of 1% for 12 months], the reduction should only be 20% [5/9 of 1% for 36 months].

But has this recalculation fully compensated Jenny for her previous loss of Social Security benefits? Section 724 of the Online Social Security Handbook at the Social Security website (www.ssa.gov) describes the calculation of reduced benefits while working. The recomputation of benefits at full retirement age is described in section 728. The website also provides examples of benefits reductions and recomputations under Retirement Planner (www.socialsecurity.gov/retire2/whileworking3.htm).

Cost-Benefit Analysis

An analysis of whether a person is undercompensated or overcompensated by the Social Security recalculation at full retirement age (because excess earnings previously led to benefit losses) requires consideration of the following:

• The person’s age;
• Full-retirement-age monthly benefits;
• Reduced benefits, due to early retirement;
• Expected Social Security benefit increases, due to inflation; and
• An assumption about the time value of money.

A spreadsheet is useful in calculating the present value of losses and subsequent gains that result from a decision to work while collecting Social Security benefits. The calculation should be tailored to each beneficiary’s situation, but some generalizations can be made by running a few simulations. Exhibit 3 graphs the present value of cumulative lifetime Social Security benefits versus the recipient’s age at death under two scenarios. In the first scenario, reduced benefits are collected beginning at age 62, and there are no further benefit reductions because of excess earned income. In the second scenario, reduced benefits are collected beginning at age 62, and the recipient loses annual benefits at ages 64 and 65 because of excess earned income. The projection also assumes that the normal monthly benefit at full retirement age is $2,267, that Social Security benefits increase annually at 2.5%, that the recipient’s normal retirement age is 66, and that the present-value discount rate is 7%.

The projection indicates that a breakeven point between alternatives occurs when the recipient is approximately 87 years old. In other words, under these assumptions, both alternatives provide the same approximate present value of Social Security benefits if the recipient dies at 87.

If this recipient dies before reaching 87, the recipient is not adequately compensated (on a present-value basis) for benefits lost due to excess earnings. Not enough time has elapsed for the recalculated, increased Social Security benefits to pay back the recipient for the benefits previously lost due to the income earned in excess of the maximum threshold before age 66.

If the recipient dies after 87, the situation reverses. A recipient is overcompensated (on a present-value basis) by the recalculation at full retirement age and the resulting upward adjustment to Social Security benefits.

The sensitivity of these assumptions can be tested by running additional scenarios. For example, when the present-value discount rate is lowered to 5%, the breakeven age of death is approximately 82 years. When the present-value discount rate is raised to 9%, the breakeven age of death is over 100 years. If present value is disregarded altogether, the breakeven age of death is about 76 years. In any case, however, the difference in lifetime benefits between alternatives appears to be no more than around $10,000.

When Is the Decision Relevant?

This analysis is relevant only when an individual has already begun receiving Social Security benefits early. In other words, the retiree is younger than his or her normal retirement age, has already registered with the Social Security Administration, is already collecting benefits, and is presently considering whether it is worthwhile to go back to work and earn more than the maximum allowable income.

It would make no sense for a person to elect early Social Security benefits knowing in advance that he or she will lose those benefits by working. For example, Jane, age 62, is considering either: 1) registering for Social Security benefits at age 62, but earning enough during age 62 to eliminate Social Security benefits for the entire first year; or 2) simply delaying Social Security registration and benefits until age 63.

Assume that Jane’s full retirement age benefit is $2,267 per month and the age 62 benefit is $1,700 month (75% of $2,267). If Jane registers for Social Security benefits at age 62, but loses those benefits the first year because of working, she will collect $1,700 during ages 63 through 65, and then approximately $1,814 per month for all remaining years (ignoring inflation adjustments).

On the other hand, if Jane simply waits until age 63 to register with Social Security and begin receiving benefits, those benefits will be $1,814 per month beginning at age 63 and all remaining years (again, ignoring inflation adjustments.) The second strategy gains Jane an additional $114 per month for ages 63 through 65.

Weighing All the Factors

The analysis above is generally needed once a person has already made the decision to collect Social Security benefits early. Typically, either personal financial constraints will require the beneficiary to collect early benefits, or the beneficiary will make the decision based upon his or her personal life expectancy (for more discussion, see “Retirement at 62: Is Receiving Social Security Early Worth It?” The CPA Journal, June 2006). Assuming that a person elects to collect early Social Security benefits, the secondary decision of whether to work before reaching full retirement age may come into play.

A person’s life expectancy and estimate of the present-value discount rate are relevant to the decision to work. The Centers for Disease Control and Prevention (CDC) estimates that the average 62-year-old person in the United States will live an additional 21 years (National Vital Statistics Reports, Vol. 54, No. 14, April 19, 2006). Simulations indicate that the present-value discount rate must be about 5% or less for the breakeven age of death to be 83 or younger. Therefore, the average 62-year-old person should not expect to be fully compensated by the excess earnings recomputation of Social Security benefits unless either: 1) he believes the present-value discount rate is less than about 5%, or 2) he believes he will live longer than the average age of 83.

Of course, life expectancy varies considerably, depending on factors such as lifestyle, sex, race, and location. In addition, the importance and estimate of the time value of money (the discount rate) varies widely from person to person. People with expectations of living far beyond the normal retirement age should expect to recoup lost Social Security benefits in the long run. People with low expectations for longevity likely will not. People who expect a lower discount rate to apply to their financial situation will tend to favor the decision to work, while those who expect a higher discount rate will not.

Whether a person’s benefits are taxed also affects the decision. The simulation above assumes that the benefits are not taxed. If the benefits are taxed (or become taxed because of the additional income received from working) then it becomes less advantageous for the retiree to work while collecting early Social Security benefits. It is difficult to generalize, however. This simulation also assumes that if a retiree works, all Social Security benefits will be eliminated. If there is only a partial elimination of benefits, the estimate will be much more complicated (and maybe not worth the effort).

A few general conclusions can be made (as stated above) about the decision to work or not work when collecting early Social Security benefits. In general, though, it is probably true that the decision to work or not work while collecting early Social Security benefits should be based on more proximate factors than whether the initial loss in benefits will be fully compensated in later years. Factors such as the need for additional income and the need to participate in useful activities may be much more relevant to a senior than the ultimate present value of lifetime Social Security benefits. Furthermore, income level and activity level in early retirement can affect both the quality and length of a senior’s life, so as to render spreadsheet assumptions unreliable. At the very least, these projections indicate that the cost-benefit differential is not so great that a senior should worry excessively over the decision to work when collecting Social Security benefits.

©2009 The New York State Society of CPAs. Legal Notices