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Social security.

On January 31, 1940, the first monthly Social Security retirement check was issued to a retired legal secretary, Ida May Fuller, of Ludlow, Vermont, in the amount of $22.54. From this humble beginning the Social Security system has grown to represent one leg of a three-legged retirement stool, the other two legs being benefits paid from tax-favored retirement plans and income received from the retirees' personal savings and investments. In 2007 the Social Security system paid average monthly benefits of $1,079 to 31,528,000 retired workers (payments totaled $364,300,000,000). (9)

Digging Deeper

The Social Security Administration maintains a very informative website at: www.ssa.gov.

Eligibility. A worker's eligibility for Social Security retirement benefits is based upon acquiring 40 quarters of coverage. In 2010 one quarter of coverage is received for each $1,120 of earnings (up to a maximum of four quarters in one calendar year). Therefore, a worker who earns as little as $4,480 in 2010 and pays $342.72 in Social Security taxes would receive four quarters of coverage (4 x 1,120 = 4,480; 4,480 x .0765 = 342.72). See Social Security Tax, page 438.

Calculation Of Benefits. The amount of retirement benefits are based on the worker's primary insurance amount (PIA), which in turn is a function of the worker's average indexed monthly earnings (AIME). In general, calculating Social Security benefits is a three-step process:

The Social Security Administration, using Social Security tax records, reconstructs the retiree's wage history. Wages in prior years are indexed by national wage growth to reflect current value. The highest 35 years are selected, averaged, and then divided by 12 to obtain the worker's AIME.

(1) Once AIME has been determined, it is plugged into a PIA formula. The following amounts are for an individual whose first eligibility begins in 2010 (the dollar amounts differ depending upon the year eligibility begins, are indexed, and are adjusted annually based on the growth in nationwide average annual wages): (10)

(a) Add 90% of the first $761 or less of AIME;

(b) Add 32% of AIME in excess of $761 through $4,586; and

(c) Add 15% of AIME in excess of $4,586.

(2) The benefit is adjusted for the age at which the worker is first to receive the benefit (there also are other categories of benefit adjustments and recalculations).

The AIME is based on the worker's earnings record after wages have been indexed. This indexing creates an earnings history that more accurately reflects the value of the worker's actual earnings in comparison to the national average wage level at the time of eligibility (i.e., it is a form of inflation adjustment). The following steps are involved in determining a worker's maximum retirement benefits (the process is referred to as the "wage indexing" method):

(1) Determine the year the worker becomes age 62. For example, assume 2010.

(2) Determine the indexing year, which is the second year before the worker reaches age 62. For example, the indexing year would be 2008 (2010 - 2 = 2008).

(3) Determine the indexing average wage for the second year before the year of the worker's eligibility for retirement benefits. The indexing average wage for the year 2008 is $41,334.97 (as published by the Social Security Administration).

(4) Count the number of calendar years after the worker reached age 21 and up to, but not including, the year of attaining age 62. For example, 40 years (from the year of reaching age 22 through the year of reaching age 61). These are called the computation elapsed years.

(5) Subtract five from the number of computation elapsed years. The number remaining (if less than two, use two) is the number of years to be used in computing the AIME. For example, 35 years (40 - 5 = 35). These are called the computation base years.

(6) List the worker's Social Security earnings for each of the computation base years (limited to the Social Security maximum wage base for that year--see Social Security Tax, page 438).

(7) Using the following formula, determine the worker's "indexed earnings" for each computation base year up to but not including the "indexing year."

Worker's Actual Earnings (up to the Social Security maximum) for year to be indexed

x

Average Earnings of All Workers for Year being Indexed (second year before age 62)/ Average Earnings of All Workers in Indexing Year

For example, assume that in 1980 the worker earned the maximum Social Security wage base income of $25,900. The average earnings of all workers for the year 1980 are $12,513.46 (as published by the Social Security Administration). The calculated worker's indexed earnings for 1980 are $85,553.93 (based on the average earnings in 2008). (11)

$25,900 x $41,334.97/$12,513.46 = $85,553.93

(8) From the list of indexed earnings (and nonindexed earnings for and after the "indexing year"), select the years of highest earnings (the number of years selected is the computation base years as determined in Step 5). Selected years need not be in consecutive order.

(9) Total the indexed and nonindexed earnings for the selected years and divide the result by the number of months in the number of selected years. This is the worker's Average Indexed Monthly Earnings (AIME). If the worker's income in each of the selected highest years (from Step 8) equaled or exceed the Social Security maximum for that year the worker would have the maximum AIME.

(10) This indexing creates an earnings history that more accurately reflects the value of the individual's actual earnings in comparison to the national average wage level at the time of eligibility.

(11) Determine PIA. For example, assume a worker's first eligibility begins in 2010 (born May 18, 1948), and his or her AIME is $4,600; his or her PIA would be $1,911.00, calculated as follows:
90% x $761   =   $684.90
32% x $3,825 =  1,224.00
15% x $14    =      2.10
Total          $1,911.00


Spouse's Benefit. A spouse age 62 or over is entitled to a spouse's benefit based upon a worker's Social Security record (provided the spouse is not entitled to a retirement benefit based on his or her own PIA equal to or larger than one-half of the worker's PIA). This monthly benefit, starting at normal retirement age, is equal to one-half of the worker's PIA; but the benefit is reduced if the spouse chooses to start receiving benefits before normal retirement age. A divorced spouse who has not remarried is also entitled to a spouse's benefit if married to the worker for at least 10 years before the date the divorce became final. The amount of a divorced spouse's benefit is the same as a spouse's benefit amount. Although the spouse's benefit ends when the worker dies, the spouse will then be entitled to a widow(er)'s benefit. (12)

Taxation Of Benefits. Under a two-tier system, up to 85% of Social Security benefits may be subject to income taxation. Under the first tier, if modified adjusted gross income (adjusted gross income plus tax-exempt income, or MAGI) plus one-half of Social Security income exceeds a base amount, an individual must include in gross income the lesser of: (1) 50% of the benefit; or (2) 50% of such excess over the base amount ($32,000 for married couples filing joint returns, zero for married couples filing separately who lived together during any portion of the year, and $25,000 for all other taxpayers). Under the second tier, if a taxpayer's MAGI plus one-half his or her Social Security benefit exceeds an "adjusted" base amount, he or she must include the lesser of: (1) 85% of the Social Security benefit, or (2) the sum of (a) 85% of such excess over the adjusted base amount, plus (b) the smaller of the amount includable under the first tier of taxation (see above), or $4,500 (single taxpayers) or $6,000 (married taxpayers filing jointly). The "adjusted" base amount is $44,000 for married couples filing joint returns, zero for married couples filing separately that lived together during any portion of the year, and $34,000 for all other taxpayers. For example, the taxable benefit would equal $8,550 for a married couple filing jointly who had Social Security benefits of $14,000, adjusted gross income of $37,000 and tax-exempt interest of $3,000:
                                                         The Lesser Of
85% of Social Security benefit                              $11,900
(85% x 14,000)
                                                               or
Modified adjusted gross income                $40,000
One-half the Social Security benefit          + 7,000

Total                                          47,000

Adjusted base amount                          (44,000)
The excess multiplied by 85%                    2,550
Lesser of amount includable under
  first tier ($7,000) or $6,000               + 6,000
Sum of 85% of excess plus smaller of amount
  includable under first tier, or $6,000                     $8,550


There is no longer any reduction in benefits once an individual reaches normal retirement age (i.e., earnings during and after the month the individual reaches normal retirement age will not reduce benefits). However, early retirement benefits will be reduced by: (1) $1.00 for every $2.00 of earnings over $14,160 during the years before the year a person reaches normal retirement age; and (2) $1.00 for every $3.00 of earnings over $37,680 during the calendar year before the month the individual reaches normal retirement age (e.g., there would be a reduction of $773 if an individual who reaches normal retirement age in April of 2010 had earned $40,000 in January thru March (40,000 - 37,680 = 2,320 3 = 773).

When To Take Social Security Retirement Benefits. Social Security retirement benefits are based upon the worker's primary insurance amount (PIA). The PIA is the monthly amount that would be paid to a worker who receives benefits at normal retirement age. The normal retirement age differs, depending upon the worker's year of birth.

A worker can take retirement benefits as early as age 62, but the amount received is calculated by reducing the PIA by 5/9 of 1% per month for the first 36 months, plus 5/12 of 1% for any additional months. For example, a worker taking payments three years prior to normal retirement age will receive only 80% of his or her PIA (i.e., 100 - (5/9 x 36) = 80). In addition, a worker who no longer pays Social Security taxes fails to increase his or her PIA.

Many authorities agree that, for the average worker, it is best to wait until normal retirement age in order to take full (unreduced) retirement benefits. Despite this, Social Security records indicate that well over 50% of retiring workers take early (reduced) benefits. Clearly, if life expectancy is less than average, then taking an early benefit is indicated. However, if an individual is in good health, and does not require the money to provide for retirement, the following table may assist in making the decision.

The above table compares the present values of the income streams produced by reduced (early) and unreduced (normal) retirement benefits. For example, using a discount rate of 4%, for the first 16 years and 3 months the present value of reduced retirement payments are greater than the present value of unreduced retirement payments (assuming retirement three years prior to normal retirement age, and 2.8% annual increases in retirement benefits); when the cross-over point is reached at 16 years and 3 months, the present value of the unreduced benefits will finally exceed the present value of the reduced benefits. Absent other considerations, a person who views the time value of money at 4% should consider early retirement if he or she expects to live less than 16 years and 3 months. On the other hand, if he or she expects to live at least 16 years and 3 months, he or she should wait until normal retirement. See also, Compound Interest & Present Value of Money, page 73.

Supplemental Security Income (SSI). This is a Federal income supplement program funded by general tax revenues {not Social Security taxes) that is designed to help aged, blind, and disabled people, who have little or no income. It provides cash to meet basic needs for food, clothing, and shelter. In 2007 average monthly benefits of $468 were paid t 7,360,000 recipients (payments totaled $41,205,000,000). (13)
Normal Retirement Age Determined By Year Of Birth

Year of       Normal Retirement     Year of     Normal Retirement
birth         Age                   birth       Age

Before 1938   65 years              1955        66 years, 4 months
1939          65 years, 2 months    1956        66 years, 4 months
1940          65 years, 6 months    1957        66 years, 6 months
1941          65 years, 8 months    1958        66 years, 8 months
1942          65 years, 10 months   1959        66 years, 10 months
1943-1954     66 years              1960 and    67 years
                                      after

Cross-Over Point *

Discount    When Reached           Discount    When Reached
Rate                               Rate

0%          12 years, 12 months     6%         19 years, 2 months
2%          14 years, 5 months      8%         24 years, 19 months
4%          16 years, 3 months     10%         49 years, 3 months

* Assumes payments begin 36 months prior to normal retirement age,
and Social Security benefit increases of 2.8% per year (the average
increase during the 10-year period 2001-2010).
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Title Annotation:Chapter 17: planning for retirement
Author:Cady, Donald F.
Publication:Field Guide to Financial Planning
Date:Jan 1, 2010
Words:2217
Previous Article:Taxation of annuities.
Next Article:Employment taxes.

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