The advantages of delaying Social Security benefits as long as possible have been widely supported by financial experts. While benefits can be claimed as early as age 62, they will grow by roughly 8 percent a year until age 70, and also will increase by the amounts of any cost-of-living increases that occur during this period.
Despite these guaranteed increases, roughly 70 percent of beneficiaries not only don't wait to claim until they turn 70, but actually file to begin receiving Social Security before they reach their full retirement age, which is 66 for current retirees. Their reasons are varied. Some people are physically worn out by demanding jobs and are forced to retire early. Others are ill and don't know that they'll live long enough to make it worth their while to defer benefits. Lastly, lots of early claimants are simply strapped for dollars.
In addition, the conventional retirement wisdom has argued that conserving retirement nest eggs should be the dominant goal of retirement planning. If taking Social Security early helps people avoid depleting their 401(k) and IRA balances, the thinking went, that's what seniors should do.
Unfortunately, that may actually be the worst retirement decision many people make. James Mahaney is vice president of strategic initiatives for Prudential Financial and an expert on Social Security. And while Prudential makes a lot of money from retirement investments, Mahaney makes a compelling case that Social Security benefits should be the most prized dollars that people try to enhance.
As Mahaney explains in an updated Prudential whitepaper, "Innovative Strategies to Help Maximize Social Security Benefits," "No other vehicle can match the combination of inflation-fighting increases, longevity protection, investment risk elimination, and spousal coverage that Social Security can—potentially making it one of the most valuable sources of retirement income."
Social Security income is so valuable, he says, that people should strongly consider drawing down their private retirement-fund balances if doing so will permit them to delay taking Social Security and boost these benefits. The reason for this counter-intuitive advice is that Social Security payments may qualify for much, much lower effective income-tax rates than income provided by liquidating holdings in private retirement accounts.
Tax-advantaged private retirement accounts let people build up nest eggs without having to pay taxes on either the contributions or earnings within the accounts. However, when it comes time to sell off account investments to produce needed income for retirement, that income is nearly always taxed as ordinary income. That means it is taxed at the recipient's highest marginal tax rate.
Social Security payments, by contrast, enjoy substantial exemptions from federal income taxes. In calculating how much of Social Security income is taxable, the government uses an annual "combined income" formula. The formula adds adjusted gross income (wage and investment income minus a few eligible adjustments), non-taxable interest, and half of a person's Social Security benefits.
If this total combined income is less than $25,000 for single taxpayers or $32,000 for a couple, their Social Security payments are totally free of federal income taxes. Starting at these levels, 50 percent of Social Security benefits will be taxable, rising to a high of 85 percent for incomes above $32,000 (single) and $44,000 (joint filers). No more than 85 percent of Social Security benefits are taxed, no matter how wealthy the taxpayer may be.
At one extreme, a person or couple with no other wage or retirement income other than Social Security would pay no income taxes on any of their Social Security payments up to $50,000 a year in benefits for a single person and $64,000 a year for a couple. This ceiling amounts to $4,167 a month in Social Security for a single person and $5,333 a month for a couple—both amounts far in excess of a person's likely Social Security payments.
Mahaney notes that even for the wealthiest taxpayers, less of their Social Security income is taxed than their ordinary income from retirement accounts—a maximum of 85 percent for Social Security versus 100 percent of ordinary investment income.
His strategy goes further, however, in noting that taxable retirement-account income increases a person's adjusted gross income and thus may boost their tax rate on Social Security benefits. By spending down IRA balances in order to defer Social Security, people are not only trading a dollar of high-tax retirement income for a dollar of lower-taxed Social Security, but they also may be reducing their future tax bite on Social Security benefits in the process.
"Many individuals will therefore pay little or no taxes when they delay Social Security and take higher Social Security income and lower IRA withdrawals," his white paper says. "Although it is not intuitively clear, it is not just retirees who are near the income thresholds of $25,000 to $44,000 who will benefit, but individuals who receive much higher retirement income as well. Prudential's research has found that many individuals with after-tax income up to the mid-$90,000 range can see significant tax savings from delaying Social Security."
"The whole wisdom of taking your income from your tax-deferred account as late as possible is, in my opinion, just wrong," Mahaney says. "The more Social Security dollars that are out there going into the [combined income] formula, the better off you are."
In addition, deferring Social Security may also create a higher lifetime benefit for a surviving spouse. "When I die, what do I want to leave my wife?" Mahaney asks. "A larger IRA or a larger Social Security benefit? It's probably going to be the Social Security benefit."