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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