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Choosing when to start collecting Social Security

Although Social Security likely won’t provide enough income for you to maintain your desired lifestyle during retirement, the benefits can still be significant. For example, someone earning $100,000 per year can expect to receive annual benefits in the neighborhood of $25,000. So, Social Security is an important factor to consider in your retirement planning — especially in deciding when to start collecting benefits.

Calculating your benefits

To qualify for Social Security benefits, you must accumulate at least 40 “work credits” during your working life. You earn one work credit for a specified dollar amount of earnings up to four credits per year. All full-time and many part-time workers can earn the work credits they need in 10 years.

Your benefits are based on the average of your highest 35 years of earnings. Earnings you receive before age 60 are indexed for inflation so that they approximate current dollars. For example, if you earned $60,000 in 1980 and retire in 2007, that figure will be more than $170,000 for purposes of calculating your Social Security benefits.

Your monthly benefit is calculated by applying a formula to your average indexed monthly earnings. You can estimate your benefits using the information provided on your annual Social Security Statement, which you should receive a few months before your birthday, or the online benefit calculator at www.socialsecurity.gov.

The amount of your monthly payment is based on when you begin to collect benefits. Normal retirement age ranges from 65 to 67, depending on when you were born. (See the chart “Normal retirement ages and reduced benefits.”) You can start collecting benefits as early as age 62, but your monthly benefit will be reduced. You can also wait until you reach normal retirement age and receive a higher monthly payment or wait longer and receive an even larger payment.

When to pull the trigger

So, how do you determine the right time to begin collecting Social Security benefits? Unfortunately, there’s no one right answer. It depends on several factors, including your health, future work plans and other sources of income, such as personal savings and employer-provided retirement plans.

If your current income isn’t enough to meet your needs, collecting benefits early may be a good idea. Your monthly benefit will be discounted, but because Social Security pays out for the rest of your life — regardless of when you start taking payments — you’ll receive payments for more years and thus may ultimately receive more total benefits.

If you plan to keep working and your income is sufficient to meet your day-to-day needs, it’s usually best to put off collecting benefits at least until you reach normal retirement age. If you take the benefits earlier, your payments will be reduced if your earnings exceed a specified threshold.

Say, for example, that you reach age 62 and elect to begin collecting Social Security immediately. Your annual benefits will be reduced by $1 for every $2
you earn over $12,960 (for 2007). Once you reach normal retirement age, however, you can continue to work without reducing your benefits, though earnings above certain amounts may subject your Social Security benefits to federal income taxes.

If you can postpone receiving Social Security benefits beyond normal retirement age, you’ll receive higher payments. (The amount increases each year until you reach age 70.) Plus, if you continue to work, waiting to collect Social Security until after you retire may reduce your income taxes on the benefits. On the other hand, waiting too long will reduce your lifetime benefits if you don’t reach your life expectancy, or even cause you to lose the benefits altogether if you die before payments begin.

Breaking even

When deciding whether to take a reduced benefit at age 62 or to wait until normal retirement age or beyond, a useful exercise is to calculate the breakeven point. Suppose, for example, that your normal retirement age is 66 and that your monthly benefit at that age would be $1,281. If you started collecting Social Security at age 62, your monthly benefit would be reduced to $961. If you waited until age 70, it would be increased to $1,691.

When comparing collecting at age 62 vs. age 66, your breakeven point is age 78 years, 4 months. At that time, your total benefits measured from either starting point would be about the same (just over $189,500). If you lived beyond that age, your total lifetime benefits would be greater if you had started collecting at 66. If you don’t live that long, your total lifetime benefits would be greater if you had started at 62.

When comparing collecting at age 62 vs. age 70, the breakeven point is 80 years, 8 months. And when comparing collecting at 66 vs. 70, the breakeven point is 82 years, 6 months.
To determine the best strategy, you need to predict whether you’ll live beyond the breakeven age, based on factors such as average life expectancy for your age, your health and your family history.

A tricky decision

Determining the optimal time to begin collecting Social Security benefits is complex. In addition to comparing expected lifetime benefits, you need to consider your work plans, other financial resources and your tax picture.

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Tax tips
Greater longevity for 529 plan tax breaks

Recent legislation makes Section 529 plans — already one of the most powerful college funding tools — even more attractive. 529 prepaid tuition plans and savings plans offer generous contribution limits and significant tax and estate planning benefits.

One of the biggest advantages of a 529 savings plan is that you can make tax-free withdrawals to pay for qualified higher education expenses. This benefit was scheduled to expire at the end of 2010, but the Pension Protection Act of 2006 (PPA) permanently extends the favorable tax treatment.

Taxes and emotional distress

Historically, personal injury damage awards and settlements were tax-free. However, 10 years ago Congress amended the tax code regarding damage awards, excluding only damages received for personal physical injuries or sickness. Since then, damages for emotional distress, mental anguish and loss of reputation — without a corresponding physical component — have been taxable. These damages are common in employment discrimination and wrongful termination cases, in which a plaintiff’s injuries may be purely nonphysical.

Recently, the U.S. Circuit Court of Appeals for the D.C. Circuit found this provision unconstitutional. The court reasoned that damages for emotional distress and loss of reputation do not fall within the constitutional definition of “income” for tax purposes, because they don’t compensate for lost wages or earnings.

Although the ruling applies only within the D.C. Circuit, it’s likely to be appealed to the U.S. Supreme Court. If you’ve received damages for nonphysical injuries or currently are involved in employment-related litigation, keep an eye out for future developments in this area.

Claiming a long-distance excise tax refund

Several months ago, the IRS and Treasury Department announced that, in light of a string of court losses on the issue, they would stop collecting excise taxes on long-distance telephone services and would refund an estimated $13 billion in excise taxes paid over the last three years. If you paid these taxes between Feb. 28, 2003, and Aug. 1, 2006, you may be entitled to a refund on your 2006 business or individual tax return. Contact your tax advisor for information about refund procedures.

Give away your IRA?

If you’re age 70½ or older, PPA allows you to make tax-free distributions from your traditional IRA to eligible charities. The distributions must be made by the end of 2007, are limited to $100,000 per year and must go directly to a qualified charitable organization.

Without this provision, you would need to take a taxable withdrawal, donate the funds to charity and then claim a charitable income tax deduction. But if your ability to deduct charitable contributions is restricted by adjusted gross income (AGI) limitations, the PPA provision offers a definite advantage because AGI limits don’t apply to such donations.

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Charitable bequests
Two goals, one strategy

Bequests (transfers of assets at death) have multiple uses, numerous benefits and flexible applications. By making a charitable bequest, you can combine estate planning with charitable giving, thus accomplishing two goals at once.

Provide future gifts

You can provide now for a future gift to your chosen charity, or charities, by including a bequest provision in your will or revocable trust. Just as your will or trust directs assets to your heirs, it can direct a bequest to charity. The charity receives the funds after your death, at which time your estate is entitled to an estate tax charitable deduction.

Reap many benefits

Besides being simple to execute, charitable bequests have many benefits:

The bequest won’t affect your cash flow or reduce your assets during your lifetime.
Assets remain in your control while you’re alive.
The bequest is revocable and can be modified.
The bequest will reduce the value of your estate for federal estate tax purposes and be exempt from state inheritance taxes.
There are no limits on the estate tax deduction (unlike the charitable income tax deduction).
Your bequest will support your favorite charities after your lifetime.

Finally, a bequest’s purpose can vary. For example, you can designate that the gift be used for a specific program or purpose, such as for children’s programs or emergency relief efforts. Or the gift can go into the charity’s general fund to be used for operating expenses or as the charity sees fit.

Customize for your needs

You can set up a bequest in such a way that it fits your situation and needs. For example, a specific bequest is just that: You designate a specific dollar amount to charity — or a specific asset. Alternatively, a residuary bequest gives the charity a percentage of the balance remaining in your estate after taxes and specific bequests have been paid. With a contingent bequest, you can make the charitable bequest payable only if an individual beneficiary is not able to inherit the funds or under other conditions that you specify.

Keep it simple

Estate planning and charitable giving are both areas with significant tax planning opportunities. Just remember that sometimes the best planning strategies are the simplest. Keeping your assets until the end, reducing your estate tax and supporting charities of your choice — it doesn’t get much better than that.

Although simple, be sure to consult with an estate planning and tax advisor when setting up a bequest (or revocable trust distribution as a bequest) to ensure that all your objectives are accomplished.

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Making the grade
Assessing your retirement plan service providers

Almost any business that has a retirement plan will turn over plan administration and investment management to outside consultants. It may be that one firm, such as a mutual fund company, brokerage firm or insurance company, will provide both services. Or, the services may be unbundled, with administrative services provided by a third-party administrator such as a CPA firm or benefits management specialist.

No matter how the duties are split, it’s important that your service providers understand and meet the needs of your company and its employees.

What does the administrator do?

The plan administrator handles the day-to-day operations of your retirement plan, including processing new enrollments, enrollment changes, loans and distributions. In addition, the administrator prepares annual forms and reports that are submitted to employees and the IRS, such as the Form 5500. The administrator also cooperates with the CPA firm engaged to perform required annual audits.

Compliance is another critical administrator duty. Your administrator needs to carefully monitor the plan’s operation to be sure it meets all IRS and other regulatory requirements. For example, if your plan requires discrimination testing, which is making sure that a plan doesn’t favor highly compensated employees over rank and file employees, then performing the testing is a key administrator service. The administrator may also help you promote the plan and provide employee education.

What services does the investment manager provide?

In addition to investing participants’ contributions through mutual funds, annuities or other investment vehicles, investment managers provide a number of ancillary services. These include daily account valuation, monthly statements, live customer service and voice response systems, and online account access.

Investment managers may also provide employee education and retirement planning. But, it’s important to note that some of the optional services may impact participant costs.

How do you evaluate the services?

When it comes to evaluating your service providers, you need to look no further than service and cost. In the case of administration, service is the more important consideration, because costs are generally low and providers are cost competitive. The risk assumed by the plan sponsor is enormous, however, if it chooses an administrator with poor service.

Poor service can lead to fewer employees participating in your retirement plans, which can, in turn, lead to discrimination issues with the plan. Moreover, if the administrator fails to perform the necessary reporting and compliance requirements, the tax-advantaged treatment of your plan will be at risk. Make sure the administrator clearly understands your needs by putting them in a written contract. After that, be sure you monitor the service provided.

For investment providers, service and cost are equally important. From a service perspective, consider whether the investment manager is making appropriate
investment choices. In other words, your plan should have a variety of investment choices to appeal to participants’ diverse interests and risk tolerance. Some plans are paring down fund choices to reduce confusion. The hope is that fewer choices that still provide a range of different types of investment options will improve participation rates.

Also track how well the investments are performing. Monitoring investment performance is part of the investment manager’s fiduciary duty, but you, as the plan sponsor, also have an obligation to compare the returns of the investment alternatives offered to those of similar types of investments and make changes if warranted.

The cost of the services provided by the investment manager is critical because it has a direct impact on the rate of return earned by the plan’s investments. Be aware that fees will vary significantly from one provider to the next. Make sure you receive fair value for the amount the plan participants are being charged.

How can you get the most value?

Your company, as the plan sponsor, is ultimately responsible and legally liable to make certain that your retirement plan is operated in such a way that it maximizes the benefit to your employees. If your service providers aren’t meeting your plan’s needs, address the issues with them immediately. A good service provider will make every effort to solve any problems promptly. And if you’re still not satisfied, make any changes necessary to ensure your plan is operated in an efficient, professional manner.

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