How are Social Security benefits counted?
Q:Can you explain how Social Security benefits are calculated? I know they’re based on an average of the last 35 years of wages before beginning to draw benefits, but is there a cap to the amount a person gets “credit” for in a particular year when calculating the average?
My wife’s income varies a great deal. Some years she doesn’t reach the annual cap for Social Security taxes. In other years she exceeds that cap by a large amount.
When averaging her 35 years of wages for purposes of calculating her retirement benefits, will the Social Security Administration give her credit for every dollar she earned in those years in which she exceeded the taxation cap, or only up to the cap (or some other cap)? — M. J., Arlington, Texas
A:Social Security benefits are based on the highest adjusted 35 years of earnings, not the last 35 years. This is important, particularly for people like your wife. Only her highest years’ earnings will be counted, up to the wage base maximum. Now $118,000, it has risen significantly over the years. She won’t get credit for any income over the wage base cap.
But don’t grieve. Not all dollars of income are credited the same. The formula for crediting contains two “bend points” where the crediting rate changes. According to the Social Security website we get a 90 percent credit for the first $856 of average indexed monthly earnings. Earnings between $856 and $5,157 are credited at 32 percent. Income over $5,157 a month is credited at only 15 percent.
Basically, wages over $5,157 a month earn only one-sixth the amount in benefits that the first $856 a month earns. In effect, the crediting of Social Security benefits is a highly progressive income tax.
Many are shocked when they learn about this. But it’s good to remember that Social Security is not a pension system that pays out benefits in direct proportion to the dollars paid in. It’s an insurance program. Its goal is to provide some amount of income for everyone.
Unfortunately, our heroes in Washington appear to have forgotten about this progressivity when they voted to tax Social Security benefits. Since the tax falls on higher earners, the ones credited at only 15 percent, it renders contributions from incomes over $5,157 a month essentially valueless.
Q:You confirmed my thoughts when you responded to a question about withdrawals from the federal Thrift Savings Plan: “...it isn’t flexible when it comes to making withdrawals.”
I am concerned about retirement next March at the age of 73 when I will be required to start making the “required minimum distributions.” I would like to leave money in the G Fund and withdraw the remainder in a rollover to an IRA managed by a longtime family advisor for my father. The advisor is now managing the funds for me. He is doing a very good job.
The idea is to take the required minimum distributions out of the safe and stable G Fund and let the other IRA funds be invested more aggressively, without concern for needing to sell funds in a down market to provide cash for required minimum distributions.
Bottom line, can you split the tax sheltered money by taking most of it out of the TSP and leaving enough in the G Fund to satisfy the required minimum distribution requirements? — M.A., Seattle, WA
A:You can make withdrawals from any single qualified plan to cover the required minimum withdrawals of all plans if you have more than one plan. So, yes, you could transfer a chunk of money in an IRA rollover to your longtime family advisor, allowing it to grow without withdrawals.
The worst that could happen is that you could live so long, and it could grow so much, that you’d exhaust the funds in the TSP account. That would force you to start taking withdrawals from the IRA rollover account. But as problems go, that would be a good one.
One thing you might consider is that advisors grow old and retire, or their good judgment can fade. As a protection from that, you might keep a portion of your growth money in the TSP, invested in the C fund that invests in large and medium sized domestic companies. Think of it as a measuring stick for your advisor— and a safety measure for yourself.
This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational puposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.