Social Security: How Taking Benefits Early Can Increase Your Net Worth

Most people are urged to wait as long as possible before taking Social Security benefits, because the size of your monthly checks increase the longer you're able to defer them, up until age 70.

But this advice ignores two important economic concepts: opportunity cost and the law of compounding returns. Indeed, as reader Mike Farabee recently pointed out to me, these factors can make a world of difference when it comes to your net worth.

The opportunity cost of waiting
The problem with many Social Security analyses is that they assume your benefits exist in a vacuum. But this obviously isn't true.

In the absence of Social Security, how is the typical retiree expected to pay bills? In many cases, the answer is that he or she will be forced to withdraw money from a tax-deferred retirement account such as an IRA or a 401(k).

And the longer the retiree waits, the more that person will have to extract.

Take the following chart as an illustration. The three lines trace the value of a hypothetical retiree's 401(k) depending on when the person elects to receive Social Security.

By taking benefits earlier as opposed to later, you're able to both maintain the balance of your 401(k) and even allow it to continue growing. Alternatively, if you wait to receive benefits and instead rely on your 401(k), then its value will immediately fall and could continue to lag for decades.

"What I am seeing is that for even a modest tax deferred growth within the 401(k) of 4%, I would have to live to 89 before taking Social Security at 67 or 70 would match the 401(k) balance by taking it at 62," Mike wrote me in an email last week.

The compounding benefit of taking benefits early
While there's no doubt that waiting to take Social Security has its advantages -- namely, that the size of your benefits grow the longer you wait -- one of its principal drawbacks is that doing so interferes with your ability to exploit the law of compounding returns.

That's because the size of your monthly Social Security benefits doesn't grow at a compounding rate. Every month you delay, they increase by a set percentage of your primary insurance amount. Between ages 63 and 66, for instance, the increase is equal to five-ninths of 1% of your primary insurance amount per month.

Alternatively, the same isn't true when it comes to investments in a retirement account. Assuming all dividends are reinvested, the money you earn in any particular year will end up compounding gains in subsequent years because it too makes money.

This is why it's often said that it takes money to make money.

Consequently, by taking benefits early you're trading out the opportunity for compounding growth with the certainty of non-compounding growth.

Is this worth it?

That's something only you can decide; however, it's certainly worth thinking about.

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Read/Post Comments (6) | Recommend This Article (16)

Comments from our Foolish Readers

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  • Report this Comment On July 05, 2014, at 8:42 AM, gadfly1000 wrote:

    This article seems largely nonsense.

    First, we don't know the sizes of the Social Security pension or 401K amount or incompressible expenses of this person's example.

    Second, 4% uncertain growth is compared with certain growth (have we already forgotten the 2008 crisis effect on 401Ks?)

    Third, the example outrageously seems to ignore both the inflation effect on the assumed 401K return AND the inflation protection in Social Security!!! The entire example is in today's dollars.

    Social Security is not compounded, but its return is 8% per year plus indexation and requires no capital investment.

  • Report this Comment On July 05, 2014, at 8:50 AM, gadfly1000 wrote:

    Add to the above that the example assumes the person DOESN'T TOUCH the 401K at all, but lets it all grow, and lives entirely on the age 62 value of Social Security, which in most cases is near poverty level income.

    Absurd.

  • Report this Comment On July 05, 2014, at 9:04 AM, wkienzle wrote:

    Additional factors not addressed are the income tax implications of taking Social Security early. Other taxable income can make otherwise untaxed Social Security distributions taxable. There is less of a risk of this if Social Security is taken later in life and turns any benefit from opportunity costs into a wash. Also, waiting to withdraw from an IRA or 401(k) will eventually put the accountholder in a position of withdrawing the Required Minimum Distribution - control of withdrawals and remaining funds is no longer fully under their control with a resulting loss of opportunity for the assets to appreciate.

  • Report this Comment On July 05, 2014, at 9:16 AM, gadfly1000 wrote:

    " There is less of a risk of this if Social Security is taken later in life"

    I'm confused. If you start SS later in life, the 50% that is used to calculate total income will be GREATER and therefore more likely to cause taxation.

  • Report this Comment On July 06, 2014, at 7:27 PM, julesvern wrote:

    Gadfly: I think the commenter is saying that if you spend some of your 401k down early, then the RMD at age 70 will be less. The higher social security income would have less taxed on it than the higher RMD.

  • Report this Comment On July 06, 2014, at 10:56 PM, levindb wrote:

    If you initially need 4% of your 401(k) to make it through the year and then adjust that amount each year by the CPI, then you would need to draw down your retirement account more each year if you start collecting SSA at 62 vs 70. That is not shown in the graph. The only draw down is shown while waiting for SSA benefits...which seems to be misleading.

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