If you think you’re ready to start collecting Social Security benefits, you might easily find yourself caught off guard. Social Security’s rules can be frighteningly complex, so it’s important to understand how the government program works and avoid unwelcome surprises that could force you to drain your retirement savings.
For example, there are limits on how much you can earn while collecting benefits, and if you exceed those limits, your Social Security benefits will get cut substantially. That’s just one of the snares that could trip you up.
Make sure you plan appropriately to stay clear of these six Social Security traps.
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You can owe tax on Social Security
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If your earnings exceed a certain level, up to 85 percent of Social Security benefits may be taxable. Even income sources that are normally tax-exempt, such as income from municipal bonds, must be factored into the total income equation for the purpose of computing tax on Social Security benefits.
Eric Levenhagen, CPA and founder of ProWise Financial Coaching, says to find out whether any of your Social Security benefits are taxable, “look at your total taxable income plus half of your Social Security benefit. Make sure you add back any tax-exempt interest income.”
Another unexpected income source that could impact taxes on Social Security: proceeds from a Roth IRA conversion.
If you’re thinking about doing a Roth conversion, do so before receiving Social Security benefits, says Steve Weisman, an attorney and senior lecturer at Bentley University. “A lot of people considering converting a traditional (individual retirement account) into a Roth IRA should be aware that if they do that, they will end up paying income tax on the conversion, which will also be included for determining whether Social Security benefits are taxable,” he says.
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IRA distributions may make benefits taxable
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Required minimum distributions, or RMDs, must generally be made from tax-deferred retirement accounts, including traditional IRAs, after a person reaches age 70 1/2. The distributions are treated as ordinary income and may push a taxpayer above the threshold where Social Security benefits become taxable.
“This is a double-edged sword,” says Weisman. “If you are over 70 1/2, you are required to begin taking distributions from IRAs (except Roth IRAs) and other retirement accounts.”
“Here again, you take half of the Social Security benefits plus all other income to determine whether Social Security benefits are taxable. RMDs will be included and drive that up,” says Levenhagen.
You can’t avoid required minimum distributions, but you can avoid being ambushed at tax time.
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You may not even qualify for Social Security
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Most people assume Social Security is available to seniors throughout the U.S., but not every type of work will count toward earning Social Security benefits. Many federal employees, certain railroad workers, and employees of some state and local governments are not covered by Social Security.
“Some of my clients have participated in retirement programs offered by employers that don’t pay into Social Security,” says Charles Millington, president at Millington Financial Advisors in Naperville, Illinois. “If your employer does not participate in Social Security, then you should be covered under the retirement program offered by your employer.”
However, certain positions within a state government may be covered by Social Security.
Find out whether your employer participates in Social Security and if not, whether your position may be covered by Social Security. Make sure you understand where your retirement benefits will be coming from.
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Take Social Security early and regret it later
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If you opt to receive Social Security benefits as soon as you are eligible, you may be doing yourself an injustice.
“If you delay taking benefits until age 70, you will see as much as an 8 percent increase in benefits for each year you delay,” says Steve Gaito, Certified Financial Planner professional and founder of Retirement Resource Management. “In addition to receiving a higher benefit, the annual cost-of-living adjustment will be based on the higher number.”
Adds Weisman, the attorney and professor: “It’s hard to find that kind of rate of return on regular investments, so it’s good to delay if you can.”
Of course, life expectancy plays a part in the decision of when to begin drawing benefits. “You generally know how healthy you are and what your family medical history is,” says Ryan Leib, financial adviser with the Keystone Wealth Management Group at UBS. “We advise clients to determine whether they think they will live longer than age 77. If so, delaying until age 70 will net you more in benefits than opting to start collecting benefits early.”
If you’re able to live off other funds, such as savings, you should seriously consider doing so. “Delaying taking Social Security until age 70 could mean the difference between cat food and caviar in retirement,” says Leib.
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Beware the ‘windfall elimination provision’
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If you work for multiple employers in your career, including both employers that don’t withhold Social Security taxes from your salary (for example, government agencies) and employers that do, the pension you receive based on the non-covered work may reduce your Social Security benefits.
“Many people are not aware that their actual Social Security benefit may be lower than the amount shown on their statements or online because the ‘windfall elimination provision’ reduction does not occur until the person applies for their benefits and (the Social Security Administration) finds out they are entitled to a pension,” says Charles Scott, president of Pelleton Capital Management in Scottsdale, Arizona.
Social Security applies a formula to determine the reduction. In 2017, the maximum WEP reduction is $442.50. There is a limit to the WEP reduction for people with very small pensions.
If you have worked for both noncovered and covered employers, don’t let the windfall elimination provision catch you by surprise.
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Still working? Your benefits may be limited
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You are allowed to collect Social Security and earn wages from your employer. However, if your wages exceed $16,920 in 2017, your Social Security benefits will be reduced by $1 for every $2 you earn above that level.
During the year in which you reach full retirement age — which ranges from age 65 to 67, depending on your birth year — you can earn up to $44,880 before $1 of your Social Security benefits will be deducted for every $3 you earn above that threshold. However, the money isn’t lost forever. You will be entitled to a credit, so your benefits will increase beginning the month you reach full retirement age.
At full retirement age, no income restrictions apply. “There is no penalty for additional income earned,” says Gaito.
If you plan on working beyond age 62 and anticipate earning more than $16,920 per year, strongly consider putting off Social Security benefits.