Tag Archives: Social Security

The Constitution or Delayed RMDs?

The Constitution or delayed RMDs?

Incredibly, Donald Trump has signed up to make that choice, starting January 20th.

How can that be? It relates to SECURE 2.0. SECURE 2.0 made dozens of additions to the already complicated retirement account rules. Many like its delaying retirement account required minimum distributions (“RMDs”) for many Americans from age 72 to age 73 (and eventually to age 75). 

But there is a big time issue few have commented on. 

It has to do with the Omnibus Bill’s purported passage in December 2022. If the Omnibus, which contained SECURE 2.0, was not passed in a Constitutionally qualified manner, any Administration enforcing it would be acting counter to the Constitution and contrary to the rule of law. 

The Constitutional Problem with SECURE 2.0

A federal judge, in a very well written and reasoned opinion, determined that the 2022 Omnibus Bill, was passed by the House of Representatives at a time the House did not have a required quorum to enact legislation. In Texas v. Garland (accessible here and here), Judge James W. Hendrix ruled for the State of Texas that the House of Representatives impermissibly used proxies to establish a quorum. The House did not have a majority of members physically present, and thus did not have a sufficient quorum to enact legislation at the time of Omnibus’s purported passage. 

The quorum rule isn’t contained in the back of a House of Representatives parliamentary procedure manual. Rather, it is contained in the Quorum Clause of the United States Constitution, making it the highest level of legal authority. 

This ruling has broad implications for SECURE 2.0. If the Omnibus was not enacted in a Constitutionally qualified manner, SECURE 2.0 is not the law of the land. Any Administration enforcing it would be enforcing a law that is simply not the law of the land.

I encourage the reader to read the Texas v. Garland opinion. I find it convincing, but you get to be the judge and jury in your own mind. 

Assuming the new Administration agrees with Judge Hendrix’s reasoning, they should announce they will not enforce SECURE 2.0 in order to avoid acting contrary to the law.

Proposed Action

I recommend that shortly after President Trump’s inauguration the IRS and Treasury issue a Notice announcing the following:

  • In order to uphold the Constitution and the rule of law, the IRS and Treasury will not enforce SECURE 2.0.
  • Considering the equities involved, the uniqueness of taxpayers having acted under an announced law that was not, in fact, the law, and the limited enforcement resources available, the IRS will not challenge any acts made, plan/account qualification, and tax return positions taken based on SECURE 2.0 prior to the issuance of the Notice. Plans and financial institutions will be allowed a reasonable amount of time to adequately account for the Notice.
  • In order to eliminate harm from detrimental reliance on SECURE 2.0, appropriate equitable remedies will be applied to prior acts taken under SECURE 2.0 with relevance going forward. For example, any Roth SEP IRAs and Roth SIMPLE IRAs properly created and funded under SECURE 2.0 will be deemed to be Roth IRAs with respect to which valid contributions were previously made.
  • The IRS and Treasury will exercise their authority under Sections 402(c)(3)(B) and 408(d)(3)(I) and waive the 60-day requirement with respect to rollovers for any SECURE 2.0 qualified distributions followed by three year repayments so long as the distribution occurred prior to the issuance of the Notice and repayment is made back to the retirement account no later than December 31, 2025. 
  • The IRS will not require RMDs and not enforce the failure to withdraw penalty for those who turned age 73 in 2023 and for those who turned age 73 in 2024.
  • The IRS will require RMDs and enforce the failure to withdraw penalty for those who turn age 73 starting in 2025. 
  • Relevant 2025 limits will be applied not factoring in provisions from SECURE 2.0. Thus, guidance such as Notice 2024-80 is modified accordingly. For example, the 2025 qualified charitable distribution limit is $100,000 and for those age 60-63 the catch-up contribution limit is $7,500.

I recommend the new Administration issue that notice shortly after Inauguration Day to uphold the Constitution regardless of whether the new Congress chooses to take additional action with respect to SECURE 2.0.

The question then becomes what to do in Congress, if anything, with respect to SECURE 2.0. Since it is likely Congress will enact significant tax legislation, there will be one or more opportunities to address the issue.

I propose that as part of the 2025 tax changes Congress passes, Congress include a provision repealing SECURE 2.0 for the avoidance of doubt. That will end any possible litigation around SECURE 2.0, since the IRS will have waived any challenges resulting from acts occurring prior to the Trump Administration, and Congress will have repealed it (in case it is the law, counter to my opinion) going forward. 

SECURE 2.0 had more to do with 401(k) plan administrators and lawyers securing full employment than securing retirement for working Americans. SECURE 2.0 being pushed to the side would be no tragedy. Perhaps Congress should salvage a few good provisions, but most of it should be left on the scrap heap while Congress focuses on more important tax reforms and extending Tax Cuts and Jobs Act individual tax cuts.

I am more ambivalent about the delays in RMDs. Congress could simply enact SECURE 2.0’s RMD delays as part of its 2025 tax reforms. That said, I believe that tax cuts such as eliminating the taxes on tips and overtime are much better tax policy and should be prioritized. 

Further, the tax benefit of eliminating the tax on Social Security potentially dwarfs the tax benefit of a one or three year delay in RMDs. There’s a very valid argument that eliminating taxes on Social Security and having RMDs start at age 72 is appropriate and will leave many seniors in a vastly improved tax position when compared to where they stood prior to 2025. 

Conclusion

I would pick the Constitution over delayed RMDs any day of the week. The Constitution is far more important than any retirement account tax rule. While it is not good to say dozens of rules that Americans have planned around are invalid, it is far worse to disregard the Constitution. 

My hope is that the new Administration’s tax policy staff, including the new Assistant Secretary for Tax Policy, work to uphold the Constitution.

The new Administration, consistent with Judge Hendrix’s ruling, should acknowledge the Constitutional problem with SECURE 2.0 and addresses it head on. Doing so will demonstrate President Trump’s commitment to honor the Constitution and the rule of law. 

Follow me on X at @SeanMoneyandTax

This post is for educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Note that a version of this proposal has been posted to the crowd sourced policy website PoliciesforPeople.com. The views reflected in this post are only those of the author, Sean Mullaney, and are not the views of anyone else.

Time to Stop 401(k) Contributions?

Ed Slott believes most Americans should not contribute to traditional 401(k)s. His recent essay on the subject is a great opportunity for the FI community to reassess its love for the traditional 401(k).

My conclusion is that for many in the FI community, traditional deductible 401(k) contributions are still the most logical path when it comes to workplace retirement saving. Below I explain my thinking. 

It is important to note it is impossible to make a blanket statement as applied to the entire FI community. 

Why the Traditional 401(k) Is Good for the FI Community

Many in the FI community have the very reasonable hope that in retirement they will have years, possibly decades, where their effective tax rate will be lower than their marginal tax rate in their working years. 

The above is true of many Americans, but it is particularly true if one retires early by conventional standards. The idea is deduct, deduct, deduct into the 401(k) during one’s working years (particularly the high earning years) and then retire early by conventional standards. Prior to collecting Social Security and/or required minimum distributions (“RMDs”), most retirees look artificially poor on their tax return. This opens up the door to affirmatively convert money from traditional retirement accounts to Roth accounts and pay tax at the lowest federal income tax brackets (currently 10% and 12%). For those who deducted contributions into the 401(k) at a 24% or greater marginal federal tax rate, this is great tax rate arbitrage planning.

Minor litigation risks aside, this strategy just got even easier for those born in 1960 and later, who don’t have to take RMDs under SECURE 2.0 until age 75. With the new delayed RMD beginning date, even those retiring as late as age 65 will have a full decade prior to being required to take RMDs to do tax-efficient Roth conversions at low marginal tax rates. For some in the FI community, this opportunity window might not be a decade long but rather a quarter-century long (if they retire at age 50). 

How Bad is the Retiree Tax Problem?

As wonderful as FI tax rate arbitrate planning might be, Ed Slott’s concern that retiree taxes will increase is not entirely unwarranted. It is obvious that the government is not fiscally responsible, and it is obvious that tax increases could be coming in the future. 

Let’s assess the situation by looking at just how bad the problem of taxes is in retirement.

We begin with a baseline case. David and Hannah are in their 70s. They never did Roth conversions in early retirement and have the bulk of their financial assets in traditional IRAs and traditional 401(k)s. During most of their working years, David and Hannah maxed out 401(k)s and got deductions in the 24% bracket or greater. For 2023, they have taxable RMDs of $160,000, Social Security of $40,000, $4,000 of qualified dividends and $1,000 of interest income. How bad is their federal income tax situation?

Federal Income Tax Return
RMDs$ 160,000
Social Security$ 40,000
15% Social Security Exclusion$ (6,000)
Interest$ 1,000
Qualified Dividends$ 4,000
Adjusted Gross Income (“AGI”)$ 199,000
Standard Deduction$ (27,700)
Additional SD Age 65+$ (3,000)
Federal Taxable Income$ 168,300
Federal Income Tax (Estimated)$ 27,361
Effective Tax Rate on AGI13.75%
Marginal Federal Income Tax Rate22%

Under today’s rules, David and Hannah, who did no tax planning other than “deduct, deduct, deduct” are doing great. Their federal effective tax rate, even with $200K of RMDs and Social Security, is just 13.75%. They incur such a low effective tax rate because their RMDs go against the 10% tax bracket, the 12% bracket, and the 22% bracket. 

While I do think David and Hannah would be in a better position had they done some tax efficient Roth conversion planning earlier in retirement, their unbridled enthusiasm for traditional retirement accounts served them well. 

Note: David and Hannah are borderline IRMAA candidates: a $199K 2023 AGI might cost them approximately $2,000 in IRMAA surcharges in 2025 (but it is possible that inflation adjustments for 2025 will prevent that from happening). This is another reason to consider pre-RMD Roth conversions at lower marginal tax rates. 

Update 8/19/2023: But what about the widow’s tax trap? If David or Hannah die, won’t the survivor get crushed by tax increases? Check out this estimate. Assuming the survivor loses the lower-earning spouse’s Social Security benefits of at least $10,000, the survivor’s marginal federal income tax rate would climb from 22% all the way up to . . . 24%!

But what about future tax increases? Okay, let’s add four tax increases to the picture and see just how bad it looks:

  1. Eliminate the TCJA increase to the standard deduction (the law reverts to pre-2018 lower standard deduction and personal exemptions). This would reduce David and Hannah’s deductions by roughly $2,740, costing them approximately $602.80 in additional federal income tax (at today’s 22% marginal tax rate).
  2. Eliminate the TCJA decrease in the 15% tax bracket to 12%. This would cost David and Hannah $2,023.50 in additional federal income tax. I’m highly skeptical that either of these two tax increases will actually occur, but as written in today’s laws they are scheduled to happen in 2026. 
  3. Increase the 15% long term capital gains and qualified dividend income rate to 25%. While I believe that the real risk is an increase in the 20% long term capital gains and qualified dividend income rate, let’s stress test things and consider a large increase in the 15% rate. In David and Hannah’s case, this costs them $400 in additional federal income tax.
  4. Increase the 22% tax rate to 33%. Ed Slott is worried about large tax rate increases, so let’s consider one that I believe is politically infeasible, a 50% increase in the 22% tax bracket. This type of tax rate increase would hit millions of voters in a major way. But it’s helpful to consider what could be a worst case scenario. In this case, this tax rate increase costs David and Hannah an additional $8,233.50 in federal income tax.
  5. There’s one more tax hike to consider: the combination of tax increases numbers 1 and 4. If both occurred together, combined they would cost David and Hannah an additional $301.40 in federal income tax. 

Here’s what David and Hannah’s federal tax picture looks like if all of the above tax increases occur:

Federal Income Tax Return
RMDs$ 160,000
Social Security$ 40,000
15% Social Security Exclusion$ (6,000)
Interest$ 1,000
Qualified Dividends$ 4,000
Adjusted Gross Income (“AGI”)$ 199,000
Standard Deduction$ (15,240)
Additional SD Age 65+$ (3,000)
Personal Exemptions$ (9,720)
Federal Taxable Income$ 171,040
Federal Income Tax (Estimated)$ 38,922
Effective Tax Rate on AGI19.56%
Marginal Federal Income Tax Rate33%

Significant tax increases hurt David and Hannah, but how much? By my math, very significant tax increases, including a 50% increase in the 22% bracket, cost them about 6% of their income. Not nothing, but wow, they’re still doing very well. 

Yes, on the margin, the last dollars David and Hannah contributed to the traditional 401(k) were not ideal since they faced a 33% marginal federal tax rate in retirement. But let’s remember (i) their overall effective rate is still more than 4 percentage points lower than their working years’ marginal rate (at which they deducted their 401(k) contributions), (ii) they have income significantly above what most Americans will have in their 70s, and (iii) in my scenario they face four separate tax hikes and still pay a federal effective tax rate less than 20 percent.

Future Retirees’ Tax Risk

Do future tax hikes pose no threat to future retirees? Absolutely not! But my stress test shows that many Americans with substantial RMDs will not get walloped even if Congress enacts unpopular tax increases. Considering many in the FI community will have modest RMDs due to pre-RMD Roth conversions, the threat of future tax hikes is even less perilous for the FI community.

Further, many Americans, particularly those in the FI community, have a great tool that can mitigate this risk: Roth conversions during retirement! With RMDs now delayed to age 75 for those born in 1960 and later, many Americans will have years if not decades where money can be moved in a tax-efficient manner from old traditional accounts to Roth accounts. 

Further, many Americans can claim deductions at work and then at home contribute to a regular Roth IRA or a Backdoor Roth IRA. This too mitigates the risk of having all of one’s retirement eggs in the traditional basket. 

Last, do we really believe that Congress is just itching to raise taxes on future retirees? Sure, it’s possible. But to my mind taxes are more likely to be raised on (i) those in higher ordinary income tax brackets and/or (ii) long term capital gains and/or qualified dividends (particularly the current 20% bracket). If anything, the most Congress is likely to do to retirees is slightly increase their taxes so as to mitigate the political risk involved in raising taxes on retirees who tend to vote. 

The Risks of Not Having Money in Traditional Retirement Accounts

Risk isn’t a one-way street. There are some risks to not having money in traditional retirement accounts. I identify three below.

Qualification for Premium Tax Credits

Picture it: Joe, age 55, retires with the following assets: (i) a paid off car, (ii) a paid off house, (iii) a $40,000 emergency fund in an on-line savings account, and (iv), $2 million in Roth 401(k)s and Roth IRAs. He heard that Roth is the best, so he only ever contributed to Roth IRAs and Roth 401(k)s, including having all employer contributions directed to a Roth 401(k). Having fallen into the Rothification Trap, in retirement Joe must work in order to generate sufficient taxable income to qualify for any ACA Premium Tax Credit. 

For at least some early retirees, the ability to create modified adjusted gross income by doing Roth conversions will be the way they guarantee qualifying for significant Premium Tax Credits to offset ACA medical insurance premiums. 

Charitable Contributions

Many Americans are at least somewhat charitably inclined. Starting at age 70 ½, Americans can transfer money directly from a traditional IRA to a charity, exclude the distribution from taxable income, and still claim the standard deduction. Essentially, if you’re charitably inclined, at a minimum you would want to go into age 70 ½ with enough in your traditional IRAs (likely through contributions to traditional 401(k)s that are later transferred to an IRA) to fund your charitable contributions from 70 ½ until death. 

Why ever pay tax on that money (i.e., by making contributions to a Roth 401(k) that are later withdrawn to be donated) if the money is ultimately going to charity anyway?

Unused Standard Deductions

Currently, the government tells married couples, hey, you get to make $27,700 a year income tax free! Why not take advantage of that exclusion every year, especially prior to collecting Social Security (which, in many cases will eat up most, if not all, of the standard deduction). 

Why be retired at age 55 with only Roth accounts? By having at least some money in traditional retirement accounts going into retirement, you ensure you can turn traditional money into Roth money tax-free simply by converting (at any time) or even distributing (usually after age 59 1/2) the traditional retirement account against the standard deduction. 

Deduct at Work, Roth at Home

I think for many it makes sense to max out traditional 401(k)s at work and contribute to Roth IRAs or Backdoor Roth IRAs at home. Why? As discussed above, traditional 401(k)s can set up tax rate arbitrage in retirement, help early retirees qualify for Premium Tax Credits, and make charitable giving after age 70 ½ very tax efficient. At home, many working Americans do not qualify to deduct IRA contributions, so why not contribute to a Roth IRA or Backdoor Roth IRA, since (i) you aren’t giving up a tax deduction in order to do so and (ii) you establish assets growing tax free for the future. 

In this post I discuss why deduct at work, Roth at home can often make sense and I provide examples where Roth 401(k) contributions are likely to be better than traditional 401(k) contributions. 

Conclusion

I believe that for many in the FI community, a retirement savings plan that combines (i) traditional deductible 401(k) contributions during one’s working years and (ii) Roth conversions prior to collecting RMDs is likely to be a better path than simply making all workplace retirement contributions Roth contributions.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Saving Social Security and Medicare

America has a retirement savings problem. To varying degrees, Social Security and Medicare support retirees. Other than for the very wealthy, a significant diminution in either program would materially hurt retirees. 

Most can agree with a simple proposition: over the long term, there are fiscal holes in Social Security and Medicare. 

I have seven proposals to address the problem. These proposals won’t solve funding problems for all time, but will move the needle significantly towards securing Social Security and Medicare. All the tax related proposals tax those who have benefited the most from the American economy and a very favorable investment tax climate. 

Before I get started, I would like to encourage the reader to endeavor to reduce his or her dependence on these programs by building up their own retirement assets and/or income streams. That said, as a practical matter both Social Security and Medicare are very important to the retirements of the vast majority of Americans. 

Who Pays to Save Social Security and Medicare?

PROPOSAL ONE: No changes to the Social Security and Medicare eligibility ages.

Some propose to increase the eligibility age for Medicare and/or Social Security full retirement age.

I believe that to be a horrible idea, for a myriad of reasons. Over the long term, there are fiscal holes in Social Security and Medicare. By definition, someone in the world must pay for those holes. If we eliminate more outlandish possibilities such as billing invading extraterrestrials and foreign plunder, most of the cost must be made up by some cohort or cohorts of Americans. Raising the eligibility ages to fix the holes simply decides that Americans in their mid-to-late 60s of all income and wealth levels are the cohort of Americans who must pay for those holes.

But why? Are 60-somethings particularly well off compared to other cohorts? I don’t believe they are, and many in their mid-to-late 60s are far worse off than the average American citizen. 

I’m not the only commentator to oppose increasing Social Security eligibility ages.

My three tax proposals below are hardly perfect. But at least they put the onus on filling the holes on those who (i) have benefited most from the recent American economy and (ii) have most benefited from America’s very favorable investment and endowment tax environment. Why shouldn’t the people who have benefited the most, and would be harmed by tax increases the least, fix the Social Security and Medicare holes?

Further, my three tax proposals have a significant advantage over delaying eligibility ages. Delaying eligibility ages is a delayed fix! If enacted in 2023, my three proposals go to work (in full!) on January 1, 2024. 

Any delay of the eligibility age will likely be at least somewhat delayed. No politician is going to vote to raise a 66 year old’s Social Security full retirement age overnight from age 67 to age 70. There’s zero chance of that. That’s demonstrated by this proposal, which proposes to increase Social Security eligibility ages by 3 years and admits that the proposal would not save money for at least 10 years! 

Would you be happy if you called a plumber to fix a leak in your sink and he responded, “Sure, happy to help, I’ll swing on by in 10 years.” No!

Further, I am not going to advocate for a politically untenable solution, and I wouldn’t recommend any politician do so either. There are plenty of solutions that can be implemented short of solutions that are guaranteed to be wildly unpopular with the electorate. 

One piece of evidence demonstrates just how unpopular cutting Social Security and Medicare are. A recent Axios-Ipsos poll (see the bottom of page 9) found that Americans generally oppose Social Security and Medicare cuts by a 7 to 2 margin. Any highly unpopular solution will ultimately be counterproductive. 

A group of Republican Congressmen argue Social Security eligibility ages should be increased in the future to account for increased life expectancy (see the bottom of page 88 of this file). I believe their argument is mistaken for two reasons. First, some increases in life expectancy are attributable to diminished infant mortality instead of increased lifespan in old age. Second, in 2020 and 2021, American life expectancy decreased.

PROPOSAL TWO: No Increase to the FICA Tax Rates (Employee and Employer)

Historically, there have been many payroll tax increases to fund Social Security and Medicare. I believe, in today’s economy, a simple payroll tax rate increase would be unfair and would hurt many Americans who have not benefited from the surge in financial markets the way the affluent have. In a world where working class workers have not experienced real significant salary increases in decades, while the stock market has soared over several decades, we can’t simply increase payroll taxes on everyone and call it fair.

Further, it might be tempting to only increase the payroll tax rates paid by employers. But this runs into two big problems. First, it’s a tax on job creation. I, for one, want employers of all sizes creating more jobs in the United States. Increasing the tax rates employers pay for Social Security and Medicare increases incentives to offshore jobs and shifts towards automation. Count me against that.

Second, increasing employer tax rates is a tax hike on the self-employed. The self-employed face many challenges. They are not a cohort that should shoulder the burden of closing the fiscal holes in Social Security and Medicare.

Tax Increases to Save Social Security and Medicare

PROPOSAL THREE: Increase the additional Medicare tax on earned income from 0.9% to 2.0% Use half the tax (1.0%) fund Medicare and half the tax (1.0%) fund Social Security.

PROPOSAL FOUR: Increase the Medicare surtax on net investment income from 3.8% to 5.0%. Use the increase (1.2%) to fund Social Security. 

These two proposals have several advantages. They incrementally increase taxes on the most successful in America in order to close the shortfalls in Social Security and Medicare. They are not taxes on employers hiring more employees, so they do not discourage hiring. Further, these two tax proposals leverage off existing taxes such that implementation of the proposals should be relatively easy. 

PROPOSAL FIVE: Impose a new 25% excise tax on net investment income of college endowments with $1 billion or more in assets as of year end.

This new tax would replace the tiny 1.4% excise tax on some college endowments enacted as part of the Tax Cuts and Jobs Act (TCJA) in 2018. 

Congress can allocate tax collections between Social Security and Medicare as they best see fit. 

Once subject to the tax, a college endowment would be subject to it going forward until the endowment can demonstrate its year-end assets have been under $750 million for three consecutive years. 

Net investment income for this purpose would be the endowment’s Section 1411(c)(1)(A) income, less the following limited expenses: salaries and benefits for employees primarily working for the endowment (limited to $20,000 per month per employee), endowment tax return preparation fees, endowment legal fees, office supplies and equipment (printers, copiers, scanners, etc.) for the endowment, and computer software for the endowment (limited to $1 million per year). Capital gains and capital losses would be netted and no net capital loss could be taken, though any net capital loss would carry forward without limit to subsequent years. 

As the excise tax taxes endowments of financial assets, dorms, classrooms, and other buildings used by the university in their educational mission would not be endowment assets for purposes of the new excise tax. 

Estimated payments would be due the same dates as individual estimates are due (and the same underpayment penalties would apply), and the net investment income of any controlled endowment entity (domestic or foreign) would also be included in the endowment’s net investment income. 

These tax-free hoards have enjoyed incredibly favored treatment long enough. Some of these endowments now exceed $1 million per student, more than enough to fund many students without collecting a dollar of tuition. 

Most colleges do not pay income tax on tuition and donations received. I don’t propose to change that, but it’s time these colleges, which mostly serve a select privileged few, pay a significant tax on their investment income. Considering these endowments are worth vast sums of money, that tax should be equal to the rate paid by highest income individuals on long term capital gains, 25% (20% long term capital gain rate plus 5% net investment income tax under my proposal).

You might think this is unfair to colleges. But let’s imagine we were tasked with creating the entire U.S. federal tax system from scratch. If I proposed to subject waiters and factory workers to both income taxes and payroll taxes on their entire salary, while exempting colleges from taxation on tuition collected and donations received, and then added a 25% net investment income tax on large endowments, you’d probably say “Wow, you’re being unfair to waiters and factory workers and too generous to colleges.” 

I don’t propose a revolution in tax policy, but rather a fair, equitable, and incremental tax change that increases the tax burden on those most able to bear it in order to combat funding shortfalls in Social Security and Medicare. 

Stabilizing The Federal Government’s Finances

PROPOSAL SIX: Significant reductions in military and foreign spending

Practically all Americans reading this are owed Social Security and/or Medicare benefits! That makes you a creditor of the U.S. government. 

Your creditor’s financial health matters to you. It’s time your creditor got its house in order. Your creditor’s house is not in order for many reasons, including spending that is consistent with neither the founding nor the history of our great republic.

Incredibly enough, the United States has nearly three times as many foreign military bases as it has embassies. It’s time to ditch the bases and bring the troops home for many reasons. Having so many military and other government personnel overseas is contrary to the great history of our republic. As John Quincy Adams said, “America does not go abroad in search of monsters to destroy.” Today’s historically out-of-whack military and foreign spending is destabilizing the government’s finances. It’s time to cut military and foreign spending significantly and redeploy that money to reduce the deficit and secure the financial stability of the federal government. 

A financially stable government is much more likely to be able to successfully meet its Social Security and Medicare obligations. 

Some might argue that neither our current level of military spending nor Social Security and Medicare are consistent with the founding and history of our country, so shouldn’t both be cut? Jeffrey Sachs has observed that there is some popular support for cutting America’s foreign military involvement. On the other hand, there is very little appetite among the electorate for reductions to Social Security and Medicare. There’s no reason to consider wildly unpopular options when there are much more popular options on the table. 

Self-Help

PROPOSAL SEVEN: Change Your Health

Not every change to improve the Social Security and Medicare system needs to come from Congress.

Over the years I have become more and more convinced that almost everything we learned about health and nutrition is wrong. It is time for each of us to radically take charge of our own healthcare. We need to do this regardless of the fiscal state of Social Security and Medicare. But my hope is this shift will reduce spending on Medicare. 

I have seen my health improve by focusing on eating high quality animal fats and proteins, avoiding seed oils (which are very new in human history), and dramatically reducing sugar consumption. One reason I continue with that focus is that, as discussed by Doctors Ken Berry and Lisa Wiedeman, sugar feeds cancer! See also Dr. Ken Berry discussing this further. Avoiding certain foods can dramatically improve health outcomes and reduce medical spending (including Medicare spending). 

My hope is that more and more Americans will become aware of the role of diet in health, and that will, over time, reduce long term medical expenses, including the expenses paid for by Medicare. Eventually, this renewed health will hopefully lead to longer life spans and increase future Social Security payments. If this happens, it hurts Social Security many years in the future. That much delayed good problem to have will hopefully be more than compensated for by earlier (and hopefully permanent) reductions in Medicare costs. 

Conclusion

As the federal government racks up more and more debt, and the clock ticks towards financial peril for both Social Security and Medicare, it’s time to take action to preserve and protect these programs. 

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute medical, accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal medical, accounting, financial, legal, investment, and tax matters. Please also refer to the Disclaimer & Warning section found here.

The above does not represent the opinion of anyone other than the author, Sean W. Mullaney. The author was not compensated by any individual or entity for writing this blog post, and this blog post does not necessarily reflect the views of any current or former employer of Sean W. Mullaney.

Sean on the Catching Up to FI Podcast

Listen as I talk tax with Becky Heptig and Bill Yount on the Catching Up to FI podcast.

You can access the podcast on Apple Podcasts.

We discuss tax planning for financial independence, particularly planning for those catching up later in their careers.

The show notes include references to the following FI Tax Guy blog posts.

The Advantages of Living on Taxable Assets First in Early Retirement

TikTok Tax Advice

Early Retirement and Social Security

HSAs and Las Vegas

This post, and the above mentioned podcast episode, are for entertainment and educational purposes only. They do not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

TikTok Tax Advice

There’s tax advice available on TikTok. Is it worth following? Does it miss the big picture?

Retirement Saving Through Various Forms of Life Insurance

TikTok tax advice often boils down to something like the following: don’t save in traditional retirement accounts where you will get crushed by taxes in retirement. Rather, save for retirement through permanent life insurance products (such as indexed universal life insurance policies) to get tax free growth and tax free withdrawals during retirement. 

Watch me discuss two problems with TikTok tax advice on YouTube.

This advice is not just offered on TikTok, though, anecdotally, it appears TikTok is at least something of a hub for promoting indexed universal life (“IUL”) and other forms of permanent life insurance. 

One recent example of this sort of advice posits a retired couple making $160,000 a year in IRA/401(k) distributions and $40K in Social Security/pension income and worries that the couple will have a terrible tax problem. 

But is that really the case? Let’s play it out with a detailed example.

Sally and Joe both turn age 75 in 2022. They are California residents. During their working years, they were prodigious savers in their workplace 401(k) plans, and their employers offered generous matching contributions. As a result, in 2022 they have required minimum distributions (“RMDs”) of $160,000. They also will have $40,000 of Social Security income, $4,000 of qualified dividend income, and $1,000 of interest income. Further, being tax savvy, they contribute $500 a month to their church through qualified charitable distributions (“QCDs”) from their traditional IRAs. They claim the standard deduction as their home is paid off and thus have no mortgage interest deductions. 

Alright, let’s see what Sally and Joe’s 2022 tax picture (all numbers are estimates) looks like:

First, their rough 2022 federal income tax return:

Federal Income Tax Return
RMDs$ 160,000
Social Security$ 40,000
15% Social Security Exclusion$ (6,000)
Interest$ 1,000
Qualified Dividends$ 4,000
QCD RMD Exclusion$ (6,000)
Adjusted Gross Income (“AGI”)$ 193,000
Standard Deduction$ (25,900)
Additional SD Age 65+$ (2,800)
Federal Taxable Income$ 164,300

Let’s turn to what their $164,300 federal taxable income means in terms of federal and California income taxes paid and their 2022 cash flow:

2022 Income Taxes and Cash Flow (Estimated)
Federal Income Tax$ 27,100
Effective Tax Rate on AGI14.04%
Marginal Federal Income Tax Rate22%
California Taxable Income (Approximate):$ 149,000
California Income Tax (Approx.)$ 7,862
Effective CA Income Tax Rate on Fed AGI4.07%
Marginal CA Income Tax Rate9.30%
Total Fed & CA Effective Income Tax Rate18.11%
Cash Flow After Fed & CA Income Tax & QCDs$ 164,038

By my math, after paying both income taxes and charitable contributions, this retired couple has $164,000 in cash flow for living expenses. Considering that, like many retirees, they live in a paid-off home, do we really believe there is a significant risk they will not be able to pay their bills? This couple ought to be able to enjoy a very pleasant, comfortable lifestyle, including recreational activities and travel.

Are Sally and Joe really getting crushed by income taxes? As residents of a high tax state, they do pay about $35K in combined federal and state income taxes. Sure, if $35K was on the table in front of you, you’d grab it pretty quick. But considering the $200K plus in cash flow they generated during the year, paying $35K in income taxes to the IRS and California is hardly financially debilitating. 

Most retired couples, even financially successful couples, will not have federal adjusted gross income of $193,000. If Sally and Joe are not crushed by income taxes (paying just an 18.11% estimated effective rate even living in a high-tax state), it is likely most retirees will be able to withstand the tax hits at retirement from having significant savings in traditional deferred retirement accounts. 

The Trade-Off Unstated on TikTok

TikTok tax advice often presents the boogeyman of taxes in retirement. It says “don’t invest in your 401(k) because it will get crushed in retirement.” Even if that were true, it usually neglects an important consideration: the upfront benefit of investing in a 401(k). 

During their working careers, it is likely that Joe and Sally were subject to marginal income tax rates of 24% or more federal and 9.3% California. Had they used permanent life insurance to save instead of using their 401(k)s, they would have lost 33 cents (or more) on every dollar in immediate tax savings, as there is no tax deduction for amounts contributed to life insurance policies.

The existence of the tax deduction for amounts contributed to a traditional 401(k) does not automatically mean that using permanent life insurance products for retirement is a bad idea. However, in weighing the tax benefits of the traditional 401(k) approach compared to the permanent life insurance approach, one must consider the immediate, and potentially substantial, tax benefits of traditional 401(k) contributions. 

One consideration in weighing the pros and cons of each: traditional 401(k) contributions generally get a tax benefit at the taxpayer’s marginal tax rate, while withdrawals from traditional 401(k)s and IRAs are more generally taxed at a taxpayer’s lower effective rate. On the way out, withdrawals are taxed through the relatively progressive tax brackets existing today, getting the benefits of the 10%, 12%, and 22% federal income tax brackets. 

Uncertainty

But, Sean, what about future tax rate increases! The federal government is running a huge deficit and it’s not getting any better.

This is a valid point. But let’s consider a few things. First, in my example, Sally and Joe were subject to a 33.3% marginal tax rate during their working years, and barely over an 18% effective tax rate during their retirement. For the math to work out to make permanent life insurance more attractive (tax-wise) than traditional 401(k)s for them, tax rates would need to be increased substantially, by over 80%. Thus, even if tax rates on retirees such as Joe and Sally were to increase 85% from current levels, the tax math might only marginally favor using permanent life insurance instead of a traditional 401(k). 

Second, if there are going to be income tax rate increases, they are more likely to be to the upper tax brackets. There are fewer taxpayers (read: voters) subject to the higher tax brackets, so those are the ones the politicians are more likely to increase. Increasing the 10%, the 12%, and/or the 22% tax brackets will impact more voters and lead to more election risk for the politicians.

Third, recent history suggests that the politicians are not likely to target retirees. It’s true that Social Security went from being tax free to being largely subject to taxation, up to 85% taxable. Interestingly enough, the second Social Security tax increase, which subjected Social Security to possibly being 85% taxable, passed through a Democratic Congress in 1993. The following year the Democrats suffered historic losses in the House and Senate elections. Many factors came into play, but it is interesting that since 1994 tax policy has generally benefited retirees (no more tax increases on Social Security, increasingly progressive tax brackets, and the increased standard deduction). 

Perhaps the politicians in both parties have learned a lesson when it comes to retiree taxation.

Is there zero risk that retirees could be subject to higher taxes in the future? Absolutely not. But, is that risk great enough to eschew traditional 401(k) contributions in favor of permanent life insurance? Not in my opinion.

Further, there are simpler, less costly planning techniques other than permanent life insurance that those using 401(k)s for retirement planning can avail themselves of, including Roth accounts and health savings accounts. 

Roth Accounts

Savers worried about future tax rate hikes have a simple, easy to implement tool to hedge against future tax rate increases: the Roth IRA. The Roth IRA solves the same tax problem that permanent life insurance solves for. In today’s environment, Roth IRAs are available at a vast array of financial institutions with very low fees. 

As I have previously discussed, many savers will benefit from the combination of a maxed out traditional 401(k) and a maxed out annual Roth IRA. 

Many will point out the possibility of much greater contributions to an indexed universal life insurance policy than to a Roth IRA. While true, many of those concerned with getting large amounts into tax-free accounts while working can turn to the Roth 401(k), which has significantly greater annual contribution limits than the Roth IRA. 

Roth Conversions

Many in the FIRE community have access to Roth conversions during what are likely to lower taxable income years. The tax idea behind retiring early is to load up on traditional 401(k) contributions during working years, and then convert amounts inside traditional retirement accounts to Roth accounts during early retirement years prior to collecting Social Security. 

In early retirement years, many in the FIRE movement appear, at least initially, to be poor on their tax return. No longer working, and not yet collecting Social Security, one’s tax return only includes interest income, dividend income, and some capital gains income. If that income is relatively low (which it is likely to be for many early retirees), it likely leaves room for Roth conversions at the 10% or 12% tax brackets during early retirement. 

This is tax rate arbitrage. First, deduct 401(k) contributions in the 24% or greater federal income tax brackets during one’s working years. Then, during early retirement, convert amounts in the traditional retirement accounts at a 10%, 12%, or perhaps 22% marginal federal income tax rate. 

Two observations: A) using permanent life insurance instead of traditional 401(k) contributions followed by early retirement Roth conversions denies members of the FIRE community a significant tax rate arbitrage opportunity. While there is no taxable income inclusion when withdrawing from a permanent life insurance policy, there is also no tax deduction for contributions to IULs, whole life insurance, and other permanent life insurance policies. 

B) By doing Roth conversions during early retirement, FIRE members reduce the uncertainty risk described above. FIRE members face a shorter time frame during which significant savings are in traditional retirement accounts, as the goal is (generally speaking) to get the money (mostly) converted to Roths prior to age 70.

The Roth conversion tool reduces the risk that future tax increases will crush savers who mostly use traditional 401(k)s during their working years. While this is true for all savers, it is most especially true for members of the FIRE community. 

A note on tax optimization: Imagine Joe and Sally were retired at age 55, today’s tax laws existed, and they had many years with artificially low taxable income. Say they did not do Roth conversions during this time. Is that a mistake? From a tax optimization perspective, absolutely. They would have likely been able to do Roth conversions at a 10% or 12% federal income tax rate, which is lower than both their retirement 22% marginal federal income tax rate and 18.11% combined effective income tax rate. While they are not tax optimized, they are something more important in my example: financially successful. Yes, tax optimization is important, but it is not the be-all and end-all. My guess is that financially successful individuals do not regret the failure to tax optimize on their deathbeds, though I look forward to reading Jordan “Doc G” Grumet’s new book to be sure. 

Conclusion

I’m not here to tell you exactly how to save for retirement. But I am concerned that TikTok tax advice has two deficiencies. First, it overstates the problem of taxation in retirement. Is there a potential problem? Yes. Is it as severe as some make it out to be? Not under today’s laws. Further, there are tactics such as annual Roth IRA contributions and Roth conversions during early retirement that can address the problem. Second, TikTok tax advice understates the current benefit of deductible traditional 401(k) contributions during one’s working years. 

Further Reading

Forbes has recently published two articles on the sorts of insurance policies frequently promoted on TikTok. They are available here and here. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

The Four Backstops to the Four Percent Rule

Introduction

Worried about an early retirement based on the Four Percent Rule? Might the 4% Rule work because of natural backstops most early retirees enjoy? 

The 4% Rule

The 4% Rule is a rule of thumb developed by the FI community. For example, JL Collins writes extensively about the 4% Rule in Chapter 29 of his classic book The Simple Path to Wealth.

Boiled down, the rule of thumb states that an investor can retire when he or she (or a couple) has 25 times their annual expenses invested in financial assets (equities and bonds). They would then spend down 4% of their wealth annually in retirement. The first year’s withdrawal forms a baseline and is increased annually for inflation.

The idea behind the 4% Rule is that the retiree would have a very strong chance of funding retirement expenses and never running out of money in retirement. As a result, some refer to 4% as a safe withdrawal rate. 

Here’s how it could look:

Maury is 50. He has $1M saved in financial assets. He can spend $40,000 in the first year of retirement. If inflation is 3% at the end of his first year of retirement, he increases his withdrawal by 3% ($1,200) to $41,200 for the second year of retirement.

The 4% Rule has a nice elegance to it. Most investors aim for a greater than 4% return. In theory, with a 5% return every year, the 4% Rule would never fail a retiree. If you spend approximately 4% annually, and earn approximately 5% annually, you have, in theory, created a perpetual money making machine and guaranteed success in retirement.

Watch me discuss the Four Backstops to the 4% Rule

The theory is great. But in practice we know that investors are subject to ups and downs, gains and losses. What happens if there is a large dip in equity and/or bond prices during the first year or two of retirement? What if there are several down years in a row during retirement? 

As a result of these risks, and stock market highs in late 2021, some are worried that the 4% Rule is too generous for many retirees. Christine Benz discussed her concerns on a recent episode of the Earn and Invest podcast. 

This post adds a wrinkle to the discussion: the four backstops to the 4% Rule for early retirees. What if worries about the adequacy of the 4% Rule for early retirees can be addressed by factors outside of the 4% Rule safe withdrawal rate? And what if those factors quite naturally occur for early retirees?  

Resources for the Four Percent Rule

These are links to articles addressing the 4% Rule and safe withdrawal rates

Cooley, Hubbard, and Waltz (Trinity University) 2011

Bengen 1994

Below I discuss what I believe to be the four natural backstops to the 4% Rule. 

Spending

A 4 percent spending rate in retirement is not preordained from on-high. Spending in retirement can be adjusted. Those adjustments can take on two flavors.

The first flavor are defensive spending reductions.  As Michael Kitces observed on an episode of The Bigger Pockets Money podcast, retirees will not blindly spend 4 percent annually without making adjustments in down stock markets.

See that the stock market is down 10 percent this month? Okay, take a domestic vacation for 6 days instead of an international vacation for 9 days. Buy a used car instead of a new car. Scale down and/or delay the kitchen remodel.

There are levers early retirees can pull that can help compensate for declines in financial assets while not too radically altering quality of life. 

The second flavor is, from a financial perspective, even better. As early retirees age, there will be natural reductions in spending. How many 80 year-olds decide to take a 12 hour flight to the tropics for the first time? There is a natural reduction in energy and interest in certain kinds of spending as one ages. It is likely that many retirees will experience very natural declines in expenses as they age. 

Social Security

For the early retiree under 62 years old, the 4% Rule must disregard Social Security. Why? Because Social Security does not pay until age 62, and many in the financial independence community delay Social Security payments beyond age 62, perhaps all the way to age 70 (to increase the annual payment).

Here is an example of how that works.

Melinda is 55. She has accumulated $1.5M in financial assets and can live on $60,000 per year. If she retires at age 55 and lives off $60,000 a year increased annually for inflation, the only financial resources she has are her financial assets (what I refer to as her 4% assets). She cannot live off Social Security payments until age 62, and may choose to defer receiving Social Security up to age 70. 

If Melinda defers Social Security until age 70, and receives $2,500 per month at age 70 from Social Security, her 4% assets now do not need to generate the full 4% once she turns 70, since Social Security will pay her $30,000 a year at age 70.

In theory, under the 4% Rule, Melinda’s Social Security is play money. Melinda funds her lifestyle with withdrawals from her financial assets, and now she’s getting additional Social Security payments. But, if her portfolio is struggling to produce the amount Melinda needs to live off of, Social Security payments provide a backstop and can help make up the difference. 

You might think “but wait a minute, didn’t Melinda significantly lower her Social Security benefits by retiring early by conventional standards? The answer is likely no, as I described in more detail in my post on early retirement and Social Security. First, only the 35 highest years of earnings count for Social Security benefits. At age 55 is it possible Melinda has 35 years of work in. 

Second, and more importantly, Social Security benefits are progressive based on “bend points.” The first approximately $12,000 of average annual earnings are replaced by Social Security at a 90 percent rate. The next approximately $62,000 of average annual earnings are replaced by Social Security at a 32 percent rate, and remaining annual earnings are replaced at a 15 percent rate. This is a fancy way of saying that reducing later earnings, for many workers, will sacrifice Social Security benefits at a 15 percent, or maybe a 32 percent, replacement rate. Even early retirees are likely to have secured all of their 90 percent replacement bend point and a significant amount of their 32 percent replacement bend point. 

I previously wrote the following example:

Chuck is 55 years old and has 32 years of earnings recorded with Social Security. Those earnings, adjusted for inflation by Social Security, total $2,800,000. Divided by 35, they average $80,000. This means Chuck has filled the 90 percent replacement bend point (up to $12,288) and filled the 32 percent replacement bend point (from $12,288 to $74,064) of average annual earnings. If Chuck continues to work, his wages will be replaced at a 15 percent replacement rate by Social Security. 

An additional year of work for Chuck at a $130,000 salary netted Chuck only $557 more in annual Social Security benefits at full retirement age! 

Real Estate

Most early retirees own their own primary residence, usually with either significant equity or no mortgage. That primary residence can be a backstop to the 4% Rule.

For example, a retiree might live in a 2,000 square foot, $500,000 home with no mortgage. During their retirement, they might decide they don’t want to maintain such a large home, so they sell the 2,000 square foot home and move into a 1,000 square foot condominium at a cost of $350,000. The $150,000 difference in sale prices can become a financial asset to backstop 4% Rule assets and help the retiree succeed financially.

Alternatively, the early retiree could sell the $500,000 home and move into a smaller apartment with a $2,000 per month rent. While the retiree has increased their expenses, they also have created $500,000 worth of financial wealth to help pay that rent and fund their other expenses.

A third option is a reverse mortgage where the retiree stays in their primary residence but gets equity out of the home from a bank. 

Real estate can serve as a natural backstop to help ensure retirees have financial security and success.

Death

It’s wet blanket time. You may be considering a 30, 40, or 50 year retirement. Unfortunately, there is a good chance that you will not live that long. Sadly, not all early retirees have a long retirement. 

As demonstrated in these tables, there is a real chance that an early retiree will not live for 25 or 30 years. That factors into whether or not the 4% Rule will work for an early retiree. 

Let’s consider a 55 year old considering early retirement using the 4% Rule. He believes that he will live 30 more years and there is a 95% chance that his assets will last 30 years. He believes that the 4% Rule has a 5% chance of failing him. Further, assume that he believes there is a 30% chance that he will die prior to age 85.

His own potential death reduces the chance that the 4% Rule will fail. Remember, failure requires that he has to both run out of assets and live long enough to run out of assets. By his estimation, the odds that both events will occur are just 3.5 percent. To figure this estimated probability, multiply the probability that he will run out of assets (5%) by the probability that he will live long enough to run out assets (70%). 

A not insignificant number of early retirees will have an early retirement that lasts (sadly) only 10 years, 15 years, or 20 years. That (again, sadly) backstops the 4% Rule. 

Early Retirees vs. Conventional Retirees

I’ve contended that early retirees have four natural backstops to the 4% Rule. What about more conventional retirees? I’ll define a “conventional retiree” as one who collects Social Security soon after retiring. 

I believe conventional retirees enjoy three of the four backstops. Sadly, they “enjoy” the mortality backstop to a greater degree than early retirees. 

Conventional retirees retiring on Social Security do not enjoy Social Security as a backstop to the 4% Rule in most cases. Here’s an example:

Robert is age 65 and is planning to retire on financial assets and Social Security. He will collect $36,000 a year in Social Security and will spend a total of $76,000 a year. To facilitate this, he will initially withdraw $40,000 from his $1M portfolio.

In Robert’s case, Social Security is not a backstop to the 4% Rule. Rather, the 4% Rule is simply one of two necessary but not sufficient sources of funds for his retirement. A failure of the 4% Rule in Robert’s case would not be backstopped by Social Security. 

Conclusion

While there are no guarantees when it comes to safe withdrawal rates in retirement and the 4% Rule, it is possible that many early retirees will succeed with the 4% Rule, for two reasons. First, the 4% Rule may, by itself, be successful for many early retirees. The second reason is that even if the 4% Rule fails, there are four natural backstops in place for many early retirees that can step in and help retirees obtain financial success even if the 4% Rule fails on its own.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Early Retirement and Social Security

UPDATE October 20, 2023: This post has been updated for the 2024 Social Security numbers.

I can’t retire early! I’ll destroy my Social Security!

Is that true? What happens to Social Security benefits when retirees retire early? Are significantly reduced Social Security benefits a drawback of the financial independence retire early (FIRE) movement? 

Below I explore how Social Security benefits are computed and the effects of retiring early on Social Security.

Social Security Earnings

Form W-2 reports to the government one’s earnings during the year. For the self-employed, the Schedule SE performs this function. The Social Security Administration tracks those earnings. 

Only a limited amount of earnings every year count as Social Security earnings. There is an annual maximum on the amount of earnings that can go on one’s Social Security record, regardless of the number of jobs one has. For 2024, the Social Security cap is $168,600. The cap is increased most years for inflation. Payroll taxes for Social Security (FICA for W-2 workers, self-employment taxes for the self-employed) are not due on earnings above the cap.

Social Security Benefits

A few very general rules need to be established as we consider the amount Social Security pays.

  1. Only the highest 35 years of earnings during one’s working years count in determining Social Security benefits.
  1. For most Americans reading this, full retirement age is 67. This means a person can collect his or her “full” Social Security benefits at age 67.
  1. Social Security benefits can be collected as early as age 62 and can be deferred as late as age 70. Collecting early reduces annual benefits (by roughly 5 to 7 percent per year) and collecting late increases benefits (by 8 percent per year).
  1. Annual earnings used in determining benefits are inflation adjusted through age 59. Earnings earned at age 60 and later are not inflation adjusted for purposes of computing Social Security benefits. 
  1. Very roughly speaking, the annual benefit is computed as follows: accumulated earnings (computed based on the rules described above) in the high 35 years are summed and then divided by 35. The resulting average annual earnings are applied against the Social Security “brackets” or “bend points.” Up to $14,088 (using 2024 numbers) of computed average annual earnings is replaced by Social Security at a 90% rate. The next $70,848 of average annual earnings are replaced at a 32% rate. Any additional amount of average annual earnings is replaced at a 15% replacement rate. The bend points are adjusted for inflation.

One need not be an expert on Social Security to see directionally how early retirement might impact Social Security benefits. Because of the progressive nature of Social Security benefits, leaving work early (by conventional standards) tends to reduce benefits less than one might initially expect. Additional earnings later in life tend to only slightly increase Social Security benefits.  

Early Retirement Social Security Example

Here’s an example to help us understand the impact of an early retirement on Social Security benefits. 

Chuck is 55 years old and has 32 years of earnings recorded with Social Security. Those earnings, adjusted (thus, nominally increased) for inflation by Social Security, total $3,100,000 as of 2024. Divided by 35, they average $88,571. This means Chuck has filled the 90 percent replacement bend point (up to $14,088) and filled the 32 percent replacement bend point (from $14,088 to $84,936) of average annual earnings. If Chuck continues to work, his wages will be replaced at a 15 percent replacement rate by Social Security. 

If Chuck retires now and earns nothing more, his annual Social Security benefits, expressed in 2024 dollars, will look something like this at full retirement age:

Replacement RateReplaced Annual IncomeAnnual Social Security at Full Retirement Age
90%$14,088$12,679
32%$70,848$22,671
15%$3,635$545
Total$88,571$35,896

Note that I rounded each bend point’s calculation. With the cents Chuck gets in each bend point, his total is increased by almost a full dollar. Similar rounding applies to the examples below as well.

At age 67, Chuck’s annual Social Security will be $35,896 (expressed in 2024 dollars).

If Chuck continues to work for one more year at a $130,000 salary, and then retires his annual Social Security benefits at full retirement age, expressed in 2024 dollars, looks something like this:

Replacement RateReplaced Annual IncomeAnnual Social Security at Full Retirement Age
90%$14,088$12,679
32%$70,848$22,671
15%$7,349$1,102
Total$92,285$36,453

Interestingly, an additional year of work only increased Chuck’s annual Social Security benefit by $557. Why is that? Remember that every dollar earned is divided by 35 for purposes of computing Social Security benefits. You can see that Chuck’s replaced income increased by $3,714 (from $88,571 to $92,285). By earning $130,000 in 2024, Chuck increased his Social Security average annual income by $3,714, which is $130,000 divided by 35.

Multiplying the increase in replaced income ($3,714) by the replacement rate (15%) gets us the additional $557 in annual Social Security benefits. 

Okay, but what about three more years of earnings. Say Chuck can work for three more years at an average annual salary of $135,000. What result (in 2024 dollars) then? 

Replacement RateReplaced Annual IncomeAnnual Social Security at Full Retirement Age
90%$14,088$12,679
32%$70,848$22,671
15%$18,920$2,838
Total$103,856$38,188

Where I come from, $1,735 ($38,188 minus $36,453) in increased annual Social Security benefits at full retirement age is not nothing. But is it worth delaying retirement for three full years if one is otherwise financially independent? To my mind, probably not. 

Spousal Benefits

What if Chuck is married to Mary? How does that impact the analysis?

During Chuck and Mary’s joint lifetimes, it depends on whether Mary collects spousal benefits. If Mary has Social Security earnings of greater than 50 percent of Chuck’s Social Security earnings, she will likely collect benefits under her own earnings record, and not a spousal benefit. Thus, Chuck’s Social Security earnings will be irrelevant to the Social Security benefit Mary collects.

If, however, Mary’s lifetime Social Security earnings are less than 50 percent of Chuck’s, Mary is likely to collect a spousal benefit of roughly half of Chuck’s annual benefit. In this case, Chuck working 3 more years creates $2,603 of additional annual Social Security income ($1,735 for Chuck and $868 as Mary’s spousal benefit). Even $2,603 in additional annual income isn’t likely to justify Chuck working for three more years.

At Chuck’s death, assuming Chuck predeceases Mary, Mary will collect the greater of her own Social Security benefit or Chuck’s Social Security benefit. Thus, Chuck increasing his Social Security earnings could increase Mary’s Social Security benefit as a widow.

I’ve got a plan to save Social Security and Medicare.

Resource

Most people I know cannot tell you their Social Security earnings record off the top of their head. But, this information is accessible by creating an account at ssa.gov. From there, Americans can obtain their Social Security statement which includes their Social Security earnings (though the statement does not adjust those annual earnings for inflation). The 2024 factors to increase annual earnings for inflation can be found by entering “2024” in the search box at the bottom of this SSA.gov website.

Conclusion

There are many factors to consider before retiring early. It is helpful to understand how Social Security benefits are computed so early retirees can understand the potential impact of retiring on their Social Security benefits. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.