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Social Security: What You Don't Know Can Hurt You

By Sean Williams - Oct 11, 2015 at 6:07AM

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You may think you understand Social Security well, but this recent survey suggests otherwise.

Source: Social Security Administration. 

Social Security is arguably the most important entitlement program for the nation's aging pre-retirees, but the scary fact is that few workers understand what the program can do for them.

Think you understand Social Security? Think again.
According to the Social Security Administration, Social Security benefits are designed to replace approximately 40% of a worker's income in retirement. However, AARP recently released a survey that examined the Social Security knowledge and perceptions of 1,215 future Social Security recipients aged 45 to 64. The results show that about half of respondents expect Social Security to comprise a majority of their household retirement income.

What's wrong with this picture? Two things come to mind.

First, when AARP surveyed 1,279 certified financial planners, 94% of CFPs noted that their clients would not likely rely on Social Security for a majority of their household income in retirement. In fact, 53% of all CFPs forecast that Social Security benefits will comprise 30% or less of their clients' income in retirement. What this implies is that pre-retirees are poor estimators of their future income streams.

The second issue with consumers' assessment that Social Security could comprise a majority of their income in retirement is that there's no guarantee that benefits won't be cut sometime between now and 2033. The retirement of 76 million baby boomers over the next two decades is reducing the ratio of workers to beneficiaries, which means more people are drawing benefits from Social Security and fewer workers are paying into it. By 2033 the cash reserves of the Social Security Trust will be used up, necessitating a 23% cut to benefits to keep the program solvent through 2087. Heavily relying on a program that could underperform inflation doesn't look promising.

Source: AARP. 

But there were other worrisome findings in AARP's analysis besides Americans' flawed expectations for Social Security.

For example, 9% of consumers believed they were "very knowledgable" about Social Security, and nearly half considered themselves at least "somewhat knowledgeable. However, when AARP posed this question to CFPs about their clients, just 1% of CFPs described their clients as "very knowledgeable" about Social Security. Additionally, more than a quarter (28%) of CFPs advised their clients to wait until age 70 to begin claiming benefits, while only 13% of the consumers surveyed plan to do so.

In sum, pre-retirees just don't have as strong a grasp of Social Security as they think -- and this could come back to bite them.

Stop leaving Social Security dollars on the table
Based on data from Financial Engines, courtesy of CNBC, single retirees have a tendency to leave more than $100,000 on the table because they fail to optimize their Social Security choices. For couples this figure grows to about $250,000.  

The data is clear as day that consumers need to take steps now to learn the ins and outs of Social Security. Consulting with a CFP is never a bad idea when you're outlining your retirement plan, but it's also important to keep a few finer points in mind.

Source: AARP.

1. Understand the timeline of the time-to-benefits correlation
There were a lot of Social Security education gaps uncovered by AARP's study, but few were as blaring as consumers' misunderstanding of the benefit claims timeline. For instance, only 61% of respondents correctly responded that age 62 is when you can first begin collecting benefits. Close to one-in-three (31%) believed it was age 63 or higher.

The silver lining here is that 88% of consumers correctly understand that waiting longer to file for benefits will result in a higher benefit check. However, some clearly don't know at what point those benefits max out.

So, to clear the confusion, Social Security benefits can be taken starting at age 62, and on the upper end they must be claimed by age 70. You're eligible to receive 100% of your payout when you reach your "full retirement age," or FRA. Your FRA varies based on the year you were born. Consumers born between 1943 and 1954 have an FRA of 66 years. However, persons born between 1955 and 1959 will see their FRA rise by two months each year, eventually hitting age 67 for everyone born in 1960 and later. On average, your Social Security benefit rises, or is lowered, by 8% per year based on when you do file a claim between age 62 and 70 in relation to your personal FRA. Thus, someone born after 1960 that waits to file until age 70 could receive about 25% more per month than if they began taking benefits at their FRA, age 67.

2. Keep the mulligan in mind
Although it's not discussed in AARPs findings, one of the little known facts about Social Security that can potentially be the most helpful is Form 521.

Typically there are no mulligans in the real world, but Form 521 is a genuine do-over for senior citizens. If you file for Social Security benefits and decide at any time within the first 12 months that you'd rather have not taken your benefits and want them to grow, you can undo your decision by filing Form 521 paying back every cent you've received in benefits. Note, your spouse may need to pay back benefits received as well.

This do-over clause is only available within the first 12 months, but it's a potentially critical tool if you land a job that can take care of your living expenses in your 60s, or if you discover that your retirement nest egg is sufficient to cover your expenses until a later time (preferably age 70, when your benefits are maximized).

Source: AARP.

3. Conquer the couples conundrum
Financial Engines also showed that one reason couples often fail to maximize their lifetime benefits is that there are about 8,000 different strategies to choose from.

But here's the good news: You don't have to understand 8,000 different strategies to optimize your benefits as a couple. Understanding two simple strategies could potentially help boost you and your spouse's lifetime benefits in a big way.

The first strategy to consider is file-and-suspend. In this strategy, one spouse (the higher earner) will file for benefits and then request a suspension of those benefits in order to allow them to grow over time. This allows the other spouse to file for spousal benefits. This is a particularly smart strategy for couples in which one spouse makes much more than the other.

The other smart strategy, filing as a spouse first, is very similar to the file-and-suspend strategy, but with one major difference. In this strategy, the lower-earning spouse files for benefits, allowing the higher-earning spouse to file spousal benefits and leave their benefit untouched (and thus allow it to grow 8% per year). The catch is that the higher-earning spouse needs to wait until their FRA before they can file for spousal benefits.

4. Know how your state treats Social Security benefits
Sometimes maximizing your benefits takes some extra planning.

As it currently stands, 13 states tax Social Security benefits, and nine of those states provide an exemption up to a certain dollar amount. This means four states -- Minnesota, North Dakota, Vermont, and West Virginia -- tax your Social Security benefits without any exemption. Where you live can have substantial bearing on what percentage of your Social Security benefits you get to keep each year. Understanding how your state handles Social Security is a critical component of your retirement planning.

Source: Social Security Administration. 

5. Understand how your payment is calculated
Finally, to maximize your lifetime benefits, it's important that you understand how your benefit is calculated.

The good news is that you don't need to know any fancy formulas here, so feel free to put that solar-powered calculator that you never use back in the junk drawer. Your estimated benefits payment will be mailed to you annually by the Social Security Administration, and you can expect it to be more accurate as you edge closer to retirement.

However, there is an important number you should be aware of regarding your retirement benefit: 35. When calculating your benefit, the SSA factors in the average annual income of your 35 highest-earning years (adjusting for inflation). The higher your average, the larger your Social Security benefit. If you don't work for at least 35 years total, then the SSA will factor in years of zero income in order to reach its total of 35 years; of course, this severely reduces your average earnings. Therefore it's best if you can work for at least 35 years in order to push your income average as high as possible, thereby maximizing your Social Security benefit.

You don't have to be a Social Security expert to succeed at maximizing your benefits. A little knowledge can go a long way toward improving your benefit payment come retirement.

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