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Understanding social security retirement benefits.

Older clients often rely on CPAs for information and advice on the computation, reduction and taxation of Social Security retirement benefits. Because Social Security benefits are an important aspect of retirement planning, CPAs need to know how these benefits are determined. . This article

* Shows how the Social Security Administration (SSA) computes retirement benefits and how this affects the decision on when to retire.

* Discusses the SSA's retirement test and presents strategies on working during retirement without a benefits reduction.

* Explains the taxation of Social Security retirement benefits and provides ideas to minimize the tax.

A worker may retire earlier or later than the normal retirement age of 65. Early retirement occurs from 62 through 64; late, after the worker's 65th birthday. The primary insurance amount (PIA) is the monthly retirement benefit a worker who retires at 65 receives. The benefits of a spouse aged 65 (or under 65 and caring for, a child under 16 or disabled) and the benefits of a dependent child are 50% of the retired worker's PIA.

The PIA for early retirees is reduced by .56% for each month of entitlement before normal retirement age; the maximum reduction is 20%, for retirement at 62. A spouse's benefits are reduced .69% for each month of entitlement before 65 to a maximum of 25% at 62. The PIA for late retirement is increased by .29% for each month of delay.

The Social Security Administration might make two errors when determining a retiree's primary insurance amount: failure to post earnings subject to Social Security taxes to the workers account and computation mistakes. Posting errors can be spotted by completing Form SSA-7004PPC, Request for Earnings and Benefit Estimate Statement, available from Social Security Teleservice at (800) 772-1213. Those who periodically dispose of tax records should be advised to complete this form before doing so. After records have been discarded, taxpayers will be unable to check if earnings subject to Social Security have been posted properly.

The Social Security Administration automatically computes a worker's PIA on retirement. The computation can be checked independently or by using published tables. [The National Underwriter Company, Cincinnati, annually publishes a SLIDE-O-SCOPE containing tables from which a worker's primary insurance amount may be obtained. The 1992 SLIDE-O-SCOPE can be purchased by calling (800) 543-0874. ] The sidebar on page 56 and exhibit 1, page 57, explain how to compute a worker's PIA.


Deciding when to retire comes down to a question of whether a worker is better off taking 80% of the PIA at 62 or waiting to get 100% at 65. Generally, the future value of full retirement payments begun at 65 will not equal the future value of reduced retirement benefits begun at 62 until many years in the future.

Consider the example of the Bowman twins, Mike and David, born in 1930. The earnings of both since 1951 were subject to the maximum Social Security tax. Mike takes reduced benefits at 62, while David waits until 65 to retire. David's primary insurance amount is $1,117 per month or $13,404 annually; Mike's PIA is $893.60 ($1,117 x .80) per month or $10,723 annually. The future value of David's annual benefits compounded at 5% for 20 years is $443,216. The future value of Mike's annual benefits compounded at 5% for 23 years is $444,259. In other words, David will not catch up in total benefits paid to Mike for about 20 years. The higher the compounding rate, the longer the catch-up period.

From an actuarial viewpoint, assuming everyone lives to the 22.5-year average life expectancy of a 62-year-old, it seems to make little difference whether retirement begins at 62 with reduced benefits or at 65 with full benefits. However, individuals in poor health or those able to produce aftertax returns higher than 5% may be better off opting for benefits at 62.


The Social Security Administration is required by law to reduce or eliminate retirement benefits using a two-part retirement test.

Earnings test. This determines if postretirement earnings fall within exempt amounts. Benefits are reduced for postretirement earnings in excess of these amounts. For those between 62 and 64, the 1992 exempt amount is $7,440. Individual and family benefits are reduced $1 for every $2 earned in excess of $7,440. For those between 65 and 69, the 1992 exempt amount is $10,200. Individual and family benefits are reduced $1 for every $3 in earnings above $10,200. These exempt amounts are adjusted annually for changes in the cost of living. (Pending legislation in Congress would raise the age 65 to 69 earnings limit to $12,000 in 1993 and by $2,000 each year thereafter until it reached $20,000 in 1997.) The earnings test does not apply to workers 70 or older or to earnings of family members who are not receiving benefits on the worker's account.

Earned income (wages and self-employment income) is included in the earnings test; unearned income is not. Wages include the cash value of all remuneration paid in any medium other than cash. Distributions to an employee for reasons other than services performed are not wages (bonuses, for example, are wages; gifts are not). Self-employment income is income from a trade or business. Among the unearned income not included in the earnings test are rental income, dividends, interest and capital gains.

Substantial services test. The substantial services test is used to determine if someone engaged in a trade or business has reduced his or her activity sufficiently to be classified as retired. A person is not considered retired if he or she continues to provide substantial services and is either actually or constructively paid for them.

Service is not substantial if the person devotes fewer than either 45 hours a month to a trade or business, unless the service requires a high degree of skill, or 15 hours a month to a trade or business, regardless of the degree of skill involved. The compensation of an individual who fails the retirement test is included in the earnings test. The substantial services test is used only for the year of retirement. Thereafter, the amount of earnings determines if any retirement benefits are lost.


The rules for determining self-employment income allow deductions for all ordinary and necessary expenses, which may be used to reduce net operating income below the exempt amount. Compensation is a deductible business expense. Family members may be employees; therefore, an unincorporated business owner can reduce self-employment income below the exempt amount by splitting business income with his or her spouse and children. Family members' earnings do not reduce the beneficiary's retirement benefits provided they are not receiving benefits on his or her account. Family members may perform skilled or unskilled services. A caveat: Family members must be reasonably 'compensated for their services.

What if the retiree is an employee? Some income can be generated either as an employee or in a self-employed capacity. For example, a life insurance salesperson can earn commissions as an employee or can be self-employed and use deductions such as wages to family members, accelerated depreciation or the election to expense certain personal property to reduce income.

The implications of excluding investment and rental income from the earnings test are clear: Stop generating earned income and start producing income not included in the test. For self-employed business owners, such a conversion is relatively easy: They sell their businesses and reinvest the proceeds in high-yielding investments.

Business owners can comply with the substantial services test and work without a benefits reduction by shifting income to another entity or person. The specifics depend on the form of business organization. A corporation is a legal entity distinct from its owners. The Social Security Administration does not have the authority to reallocate corporate earnings to particular shareholder-employees if they choose to work for low or no pay and receive no remuneration, either actually or constructively, in excess of the exempt amount, as wages, salary or dividends.

Shareholder-employees can take the following steps to maximize retirement benefits and continue working:

* Between the ages of 62 and 69, work for low or no pay.

* Let all corporate earnings in excess of the exempt amount accumulate in retained earnings until age 70.

After age 70, accumulated earnings may be withdrawn by declaring a dividend without a benefits reduction, because there is no earnings limitation for beneficiaries 70 or older. (There may, however, be adverse tax consequences, such as the accumulated earnings tax.) This strategy is effective for C, S and professional corporations.

Working for low or no pay in an unincorporated business causes problems with the substantial services test because there is no legal distinction between the business and its owner. Unincorporated businesses can incorporate and follow the strategy outlined above; however, it is not necessary to do so to meet the substantial services test.

An alternative to incorporation is to transfer the business to another family member. To satisfy the substantial services test, the transfer must be bona fide. All state and federal laws pertaining to a business transfer must be adhered to strictly. Otherwise, the Social Security Administration may deem the transfer a sham and reallocate the business income to the beneficiary. Between 62 and 69, the beneficiary can be an employee of the transferred business and earn wages or salary up to the exempt amount.

After age 70, the business can be transferred back to the beneficiary. Whether this makes economic sense depends on individual circumstances. For example, it makes sense to transfer a business from the beneficiary before 62 and back again after 70 when there is a considerable difference in the transferor's and transferee's ages.

Suppose a husband is at least eight years older than his wife. In anticipation of his retirement at 62, the husband transfers his unincorporated business to her. At the time, the wife does not have enough quarters of credit to qualify for Social Security retirement benefits on her own account. By transferring the business back to her husband when he reaches his 70th birthday, she can collect retirement benefits on her own account, and her husband can receive full benefits while operating the business because his benefits are no longer subject to the earnings limitation. Further, his wife's benefits will not be reduced by his earnings.


Social Security benefits are included in the taxable income of the person who has the legal right to receive them. The amount subject to tax is the smaller of one-half of the benefits or one-half of modified adjusted gross income (MAGI) in excess of the base amount. MAGI is adjusted gross income (not including the taxable portion of Social Security benefits) plus nontaxable interest income, plus one-half of the benefit amount.

The base amount is $25,000 for an individual, $25,000 for a married couple not filing jointly and not living together at any time during the year, $32,000 for a couple filing jointly and zero for a couple filing separately if they lived together for any part of the year. Since the tax system of many states is tied to federal MAGI, a retiree's benefits also may be subject to state tax.

Social Security recipients may incur incremental tax liabilities by making investments generating currently taxable income. Exhibit 2, above, shows how investment income may result in taxation of 50% of Social Security benefits of single or married taxpayers.

Exhibit 3, page 59, shows taxable investment income can cause 50% more income to be taxed than actually is received, regardless Of whether the income is taxable or tax-free. Two consequences of increased taxes are a reduced aftertax yield and an increased effective marginal tax rate. In exhibit 3, part 1, taxable interest income reduces a 7% pretax yield to a 3.32% aftertax yield and increases the effective marginal tax rate from 35% to 52.57%. In part 2, because tax-free interest income is included in MAGI, otherwise nontaxable Social Security benefits are taxed, reducing the taxfree yield from 6.5% pretax to 5.36% aftertax and increasing the effective marginal tax rate from 0% to 17.54%.


Certificates of deposit generally are the investments of choice for retirees, many of whom avoid complicated or risky investments regardless of their financial objectives. When income is the objective, municipal bonds produce the best results. Even though they are included in MAGI, their interest produces higher aftertax yields in all tax brackets.

When growth is the objective, the tax on Social Security benefits may be reduced by converting investment income to a form not included in MAGI. Many insurance companies offer CD annuities with rates comparable to or higher than bank CDs. Contracts are renewed every one or more years, and interest accrues tax deferred until withdrawn. Income recognition may be delayed until the beneficiaries are not subject to additional tax consequences or until the contract holder has abnormally low taxable income.

For insurable retirees, another way to eliminate eventual annuity taxation is to buy single premium whole life insurance, as accrued interest is paid as a nontaxable death benefit. This becomes necessary when the heirs are in a higher tax bracket than the insured.

With stocks, bonds and mutual funds, taxes can be deferred by using variable annuities or variable life insurance. Many mutual fund families have similar portfolios available in these products to shield dividends and capital gains from tax. A variable annuity's basis, however, is not "stepped up" at death, and no favorable capital gain treatment is available. Variable life eliminates these drawbacks by having accumulated dividends and capital gains paid to the beneficiary as a nontaxable death benefit.


As the population ages, CPAs are increasingly called on to advise clients about maximizing Social Security retirement benefits. This article shows three ways of doing so: retire early, structure retirement affairs so income in excess of the annual exempt amount can be generated without having Social Security benefits reduced and choose investment vehicles to minimize income taxes and maximize aftertax income.

HANS SPROHGE, CPA, PhD, is associate professor, Department of Accountancy, Wright State University, Dayton, Ohio. A member of the American Institute of CPAs tax policy committee, he serves on the tax legislation committee of the Ohio Society of CPAs and is chairman of the editorial advisory board of the Ohio CPA Journal. CARL A. BROOKS, CFP, is a vicepresident of Carroll Financial Associates, Inc., Charlotte, North Carolina. He is a registered principal of Keogler, Morgan & Company, Inc.


* SOCIAL SECURITY BENEFITS are an important aspect of retirement planning. As a result, CPAs need to be familiar with how benefits are determined, under what circumstances they will be reduced and what portion may be taxable. * FOR SOCIAL SECURITY purposes, normal retirement age is 65. Retirement at 62 will result in a 20% benefits reduction. Retirement after 65 results in higher benefits. Taxpayers need to make sure all earnings subject to Social Security taxes have been properly credited to their account.

* THE FUTURE VALUE of normal retirement benefits begun at 65 does not equal the future value of reduced retirement benefits begun at 62 until many years in the future. Individual circumstances also are important in deciding when to retire.

* EARNINGS DURING retirement are limited, depending on the taxpayer's age. In 1992, beneficiaries between 62 and 64 can earn $7,440; those between 65 and 69 can earn $10,200 before benefits are reduced. There are no limits for those 70 or older.

* CAREFUL PLANNING WILL enable a taxpayer to continue working during retirement while still receiving maximum Social Security benefits. Business owners have the most planning flexibility because they can control how much they earn.

* UP TO ONE-HALF OF Social Security benefits are taxable if income exceeds certain amounts. Certain investments will, however, allow some taxpayers to minimize the benefits subject to tax.


The American Institute of CPAs developed a brochure, Planning for the Future: Your Social Security Benefits, that members can purchase for distribution to clients seeking more information about Social Security benefits.

The brochure, presented in a question-and-answer format, explains how Social Security works and how to maximize benefits. A speech for delivery to business, civic and consumer groups, "What You Should Know About Your Future Social Security Benefits," also is available. Brochures (product no. 890518, $17 per 100 copies) and copies of the speech (product no. 890662, $4 each) are available by contacting the AICPA order department at (800) 334-6961 [(800) 248-0445 (in New York State)].
COPYRIGHT 1992 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Author:Brooks, Carl A.
Publication:Journal of Accountancy
Date:Aug 1, 1992
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