Many retirees who are between age 62 and their full retirement age for Social Security purposes are surprised to learn that their Social Security benefit may be reduced because they work in retirement. This forfeiture is not a tax. Instead, it's an actual reduction in the Social Security benefit they receive. To determine whether work in retirement may affect your benefits, you need to understand when and how this forfeiture occurs and how that situation might affect your overall finances.

Many retirees supplement their income through work. That work may affect their Social Security retirement check because current law imposes an earned income limit on those who draw retirement benefits. Simply put, earned income for Social Security purposes is income derived solely through gainful employment -- nothing else. If you work in retirement and get paid for that work, then you have earned income. If you don't work and your income comes solely from sources such as interest, dividends, IRAs, pensions, and retirement plans, then you don't have earned income. It's true that these items will be included on your income tax return for taxation purposes, but they are not included in any earnings limitation test for Social Security purposes.

How earned income reduces benefits
The Social Security earnings limit for retirement benefits changes annually based on inflation, and this limit affects only retirees younger than their full retirement age (FRA). Further, only the benefit of the person working is affected, not that paid to other family members. This year, those who are between the ages of 62 and FRA (age 65 and four months in 2004) may earn up to $11,640 without losing any part of their Social Security retirement benefit. If they exceed that amount, though, they will lose $1 in benefits for every $2 of the excess.

The point at which you will lose all of your benefits is easy to determine. Simply multiply your annual benefit by two, and then add $11,640 to that result. As an example, this year the average Social Security retirement benefit is $930 per month, or $11,160 per year. Multiply $11,160 by two, and you get $22,320. Add the earnings limit of $11,640 to that result and you get $33,960, the total actual wages at which the all of the Social Security retirement benefit is forfeited this year for someone younger than FRA who draws the average benefit. In actual dollars, your personal total forfeiture point may be lower or higher depending on the size of your retirement benefit. Regardless, you may still work at a job and earn right up to $11,640 this year without losing one cent of your Social Security check.

Retirees who work after they reach FRA are not subject to an earnings limit. They may earn all they want from a job and continue to receive their full Social Security retirement benefit. Still, in the year they will reach FRA, they remain subject to an earnings test for all months in which they work and are younger than FRA. But this earnings test is slightly different than the one we discussed earlier. For those who work and who will reach FRA in 2004 (65 years and four months), the SSA must deduct $1 from their benefits for each $3 they earn above $31,080 until the month they reach FRA. To see how that limit works, let's look at a quick example.

Let's say I was age 64 on Jan. 1, draw the average benefit of $930 per month, and will earn $33,000 before I reach my FRA of 65 and four months in August. That exceeds the earnings limit of $31,080 by $1,920. Therefore, I must forfeit $640 of my benefit for the year. However, I will still collect Social Security checks that total $10,520 for the year. And should I be energetic enough to do so, next year I can continue to work and earn as much as I want without forfeiting a dime of my Social Security benefit.

A word of warning
If you are under age 65 and return to work after you begin receiving your Social Security benefit, estimate what you will earn for the year, and compare that amount with that year's maximum earnings limit. If you see you will exceed that limit, tell Social Security immediately. The agency will reduce your monthly check accordingly. Fail to do so, and those earnings will be reported to Social Security anyway when you file your income tax return for the year. The Social Security Administration (SSA) will then notify you of an overpayment because of excess earnings. It will recoup that overpayment from the following year's checks. You might not be working that year and may need your full Social Security payment.

What if your estimate was wrong and you didn't earn as much as you thought you would? In that instance, the SSA will restore the previously withheld benefit. You won't have lost a penny, but you will have avoided an overpayment that could be collected later from checks you really need.

For more on making the most of your post-employment income, visit The Motley Fool Retirement Center.

In the interest of full disclosure, we must report that Dave Braze is happily retired and has reached his FRA. Fortunately for him, that means we can pay him very handsomely to answer the questions of Rule Your Retirement subscribers, and he doesn't have to worry about losing any of his Social Security check. But even if he weren't of full retirement age, the paltry sum he receives for his efforts with The Motley Fool wouldn't cause him to lose anything anyway.