Understanding Social Security

It's highly unlikely that you will be able to retire on Social Security payments alone, but for many of us it will be a significant source of income. So it's important to understand the system and the options available to you.   That is what we review in this section.

In order to draw Social Security you must have earned 40 credits.  Most people working fulltime earn four credits a year, so you only need to work for 10 years to meet that requirement.  However, the amount that Social Security will pay (your "income benefit" in govermentese) is based on the average of the highest 35 years of your "covered earnings" (earnings up to the Social Security wage base for that year).  The maximum earnings subject to FICA in 2008 is $102,000.  If you have less than 35 years of covered earnings, zeroes are used to bring the total years of earnings up to 35.  Based on this 35-year average, the government calculates your benefit, using a complicated formula.  [What's the  maximum if you hit the cutoff every year for 35 years?] Once a year the Social Security Administration should send a statement to you showing your reported earnings and your estimated benefit.  If you have worked less than 35 years by the time you hope to retire, or have a few years with lean earnings, continuing to work for a few more years can dramatically boost your benefit.  Otherwise there is only one thing you can do to influence the calculation of your benefits. (Find out more at http://www.doublingsocialsecuritysecret.com)

However, the benefits levels calculated by the government assume you retire at "full retirement age," and you can in fact retire later or earlier.  The choice of when you retire has a big impact on the benefit you actually receive.  The full retirement age for older baby boomers (people born in the years 1943 to 1954) is 66.  The retirement age then creeps up two months a year until it reaches people born in 1960 or later, whose full retirement age is 67.

If your full retirement age is 66, you can start drawing benefits as early as 62, but your benefits will be reduced according to the following schedule:

            25 percent at age 62
            20 percent at age 63
            13 1/3 percent at age 64
            6 2/3 percent at age 65

For example, if your full retirement age benefit is $1600 per month, but you start taking benefits at age 63, your monthly benefit would be $1280 ($1600 less 20%).  Many people have made this calculation and decided to take a reduced benefit as soon as they can.  They calculate that in terms of cumulative benefits received, with the four-year headstart they get by starting at age 62, they will be ahead of the game until they reach age 77. 

If you take the opposite tack and decide to delay collecting Social Security until after you reach the full retirement age, you will get an additional 8% for each year you delay once you finally do retire. 

Many financial experts advise against taking benefits early.  They point out that if you are married, your spouse will collect a survivor benefit after you die which will be based on your benefit.  Second, no more than 85% of your social security benefits are taxable, whereas withdrawals from retirement accounts are 100% taxable, so in later years you will appreciate having the higher social security payments and paying less tax.  Finally, while many of us are pessimists and fret about dying early and not collecting much from Social Security, the reality is that people are living longer and possibly outliving our savings.  In that case getting a fatter Social Security check, which is indexed to inflation, could prove to be the smart strategy.