More than one-third of Americans claim Social Security benefits as soon as possible at age 62. But that's probably not the best choice for most people. While some may be using Social Security as a literal lifeline -- they're in poor health and need the money -- many would be better off delaying those benefits as long as possible. Here's why.
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How Social Security benefits are calculated
Let's review how claiming benefits early or delaying benefits impacts your monthly payment.
The first concept to understand is full retirement age (FRA). The benefits you would receive at your FRA are used to determine your benefits for claiming earlier or later. For those considering taking Social Security benefits in the near future, their FRA is between 66 and 67 years old.
If you claim benefits early, the amount is reduced by 5/9 of a percent for each month you claim benefits before your FRA, up to 36 months. Then the benefits are reduced by 5/12 of a percent for each additional month. That means if your FRA is 67 and you claim at 62, you'll only collect 70% of your FRA benefit.
On the other hand, delaying Social Security earns you an additional 8% on your benefit per year. So, delaying from an FRA of 67 to 70 means you'll collect 124% of your original benefit.
The trade-off is that you'll collect benefits for a shorter amount of time by delaying. Still, the reductions and additions to benefits are designed to produce a breakeven outcome based on actuarial data. The expected value of total payments is the same for someone collecting early versus delaying.
If that's the case, why should someone consider delaying retirement as long as possible?
How claiming early impacts your finances
Hopefully, your retirement has several sources of income to fund your living expenses. You might have a retirement account like an IRA or 401(k), a regular brokerage account, and cash savings in addition to Social Security benefits. These sources have different tax treatments that allow you several opportunities to minimize your tax liability in retirement.
The most opportune time to do tax planning is right after you retire and your regular income goes to nearly zero. You can make Roth conversions to reduce balances in traditional retirement accounts and lower the required minimum distributions you'll face in your 70s. You may be able to harvest capital gains at the 0% capital gains tax rate. Both strategies will ensure you keep your taxes low throughout retirement. Taxes can be a big expense that eats into your retirement savings.
However, if you add Social Security benefits into the mix, they can throw a wrench into your tax planning. That's because some Social Security benefits can be exempt from taxes, but as your income climbs, a greater percentage of your benefits becomes taxable. That can result in astronomically high marginal tax rates because you're effectively getting taxed twice on each marginal dollar of income. That means strategies like capital gains harvesting or a Roth conversion could be taken completely off the table.
The most important reason to delay
But minimizing your tax liability over the life of your retirement isn't even the most important factor to consider. A bigger problem would be outliving the rest of your retirement savings.
You may live well past the average life expectancy. That's when you'll need the biggest Social Security benefit you can get. In other words, delaying Social Security is like buying insurance against living a very long life.
While the expected outcome is that you'll collect the same amount in benefits whether you claim early or delay until 70, the actual results for each individual can vary widely. Unfortunately, some people will die in their 60s before collecting a penny of Social Security. Others will live to be over 100 years old. Imagine how you'd feel if you took a permanently lower Social Security payment at 62 and lived to the age of 95. Conversely, you're highly unlikely to regret delaying Social Security.
So, not only does delaying Social Security allow you to do better retirement planning and get your finances in order, it provides very valuable insurance for your retirement.
