Are you prepared financially for retirement? Do you know how much money you will need, how much you should be saving and investing now, and what kind of lifestyle you will have?
Have you considered how inflation, layoffs, and unforeseen medical expenses could affect your plan?
In this series of articles we explore these issues and more to provide you with information to help you plan for a comfortable retirement.
Will Social Security be Enough?
Social Security retirement benefits provide most workers in the United States with a monthly income once that worker reaches retirement age. In order to qualify for this benefit the following conditions must be met:
- You must be a U.S. citizen or lawful alien resident
- You must work and pay Social Security taxes (these are usually deducted and paid by your employer)
- You must earn a minimum of 40 credits – equivalent of working full time for 10 years
Social Security benefits are funded by payroll taxes that your employer deducts automatically from your pay. The amount of the tax is 6.2% of your earnings up to a maximum amount ($117,000 for 2014). Any amount you are paid above the maximum amount is not taxed.
Your employer pays an additional 6.2% for a total of 12.4%.
It may be a surprise to learn that Social Security retirement benefits are not intended to replace all of your preretirement income.
In fact the Social Security, Retirement Benefits pamphlet (https://www.ssa.gov/pubs/EN-05-10035.pdf) clearly states on page 8, “In deciding when to retire, remember that financial experts say you’ll need 70-80 percent of your preretirement income to have a comfortable retirement. Since Social Security replaces only about 40 percent of preretirement income for the average worker, having pensions, savings, and investments are important.”
Please note that receiving 40% of your preretirement income mentioned above is for the “average worker”. You may actually receive a much smaller amount as we will explore later.
The earliest you can start receiving benefits is age 62 however your benefit amount will be reduced (by approximately 25%) compared to your full retirement age.
Your “full retirement age” is the age you can retire and receive the full amount you are entitled to. For most people this is between 66 to 67 years of age, depending on when you were born.
You can also choose not to begin receiving benefits until age 70 and receive a larger monthly benefit which would be approximately 8% larger per any individual year past your full retirement age, up to age 70.
How Much Can You Expect to Receive?
So how do you know how much you will receive when you retire? The Social Security Administration has a website that allows you to estimate your benefit amount here: www.socialsecurity.gov/estimator
The process is illustrated below for someone born in 1953 and retiring in 2015:
- Enter your actual earnings for a given year, but not exceeding the amount in the “Max Earnings” column. If you have no earnings for a given year enter 0.
- Multiply the amount in the “Your Earnings” column by the corresponding “Index Factor” and enter the result in the “Indexed Earnings” column.
- Add together the 35 years of Indexed Earnings that are the highest amounts.
- Divide this number by 420. This is your average indexed monthly earnings.
- Calculate your monthly retirement amount:
- Multiply the first $826 of your average indexed monthly earnings by 0.9
- Multiply the amount of your average indexed monthly earnings between $827 and $4980, if any, by 0.32
- Multiply the average indexed monthly earnings exceeding $4980 by 0.15
- Add the amounts in 1), 2), 3). This is your monthly benefit upon reaching your full retirement age. If you are retiring at age 62 instead, your monthly benefit is reduced by 25%.
NOTE that the chart used in this example is for someone born in 1953 and reaching age 62 in 2015. Your chart and the specific Max Earnings and Index Factors to be used will depend on your year of birth. There are however a few key points that apply to all recipients of Social Security retirement benefits as indicated in the discussion that follows.
First we can see that the maximum benefit amount is capped. That is, the benefit that you receive is proportional to how much you earned in wages, but up to a certain point. Anything you earned exceeding this amount does not result in an extra benefit.
For example if you earn the maximum amount every year (which is $117,000/year for 2014 or $9750/month) then you receive $2686 per month. This is 30% of your average indexed monthly earnings, and 28% of your most recent earnings. As you can see this is significantly less than the 40% average amount mentioned in the Social Security pamphlet.
If instead you earn double the maximum amount every year ($234,000/yr or $19,500/month for 2014) then you still receive $2686 per month. You have exceeded the cap and your benefit amount represents only 14% of your most recent earnings.
The good news is that the cap also applies to any Social Security tax taken from your pay. Any amount you earn exceeding the yearly max ($117,000 for 2014) is not taxed.
A Few Examples
Next let’s explore what happens if you are earning the maximum amount but only over the last 20 years and none over any other time frame. In that case you receive $2118 per month. Even though you qualify for Social Security benefits after 10 years of working, the amount you receive is based on your wages over 35 years.
And what happens if you are earning the maximum amount but only working over the last 10 years? Your monthly payment is $1336.
Here are a few more scenarios.
If you earn the average amount that other workers in the U.S. earned you receive $1677 per month which is 45% of your monthly average indexed earnings (averaged over 35 years), and 43% of your last year’s earnings.
If you earn half of the average amount then you receive $1078 per month which is 58% of your average indexed monthly earnings, and 56% of your most recent earnings.
What if you are laid off from your job and unemployed for some time?
The good news is that the SSA will pick your highest indexed yearly salary to calculate your 35 year average. So if you were available to work for a total of say 40 years and you were laid off a total of 5 years you still have 35 years of income for the calculation, which means in this case you don’t take a hit for the missing years.
You may have noticed in the examples above that the retirement benefits you receive as a percentage of you average indexed earnings is smaller with higher incomes. Indeed, lower wage earners in fact receive a higher percentage of their preretirement income when they retire. This can be seen in the chart below. The X axis represents actual indexed earnings as a percentage of SSA’s maximum taxable earnings:
Another factor to keep in mind is that SSA benefits may be taxable. If the total of 50% of your Social Security income plus your income from other sources is between $25,000 and $34,000, you will likely pay taxes on 50% of your Social Security income. If the total is more than $34,000 then you will pay taxes on 85% of your Social Security income. These numbers are for taxpayers filing as “single”.
If you are married filing jointly the thresholds are $32,000 and $44,000.
You can learn more about benefit taxes at https://www.ssa.gov/planners/taxes.html
Adjustments for Inflation
What about inflation in the price of goods and services? Does Social Security account for that? Well, yes and no. There are cost of living adjustments (COLA) made to your payments on a yearly basis. These adjustments are intended to protect your purchasing power from the effects of price inflation.
But do COLA adjustments keep up with your price increases? The COLA for 2014 is 2.5%. https://www.ssa.gov/news/cola/ This applies to all Social Security recipients. But if your actual costs are rising faster than this you are falling behind.
Let’s say you have $10,000 in yearly Social Security income and your expenses are $10,000. The chart below shows what happens to your expenses and income over a 10 year period if your actual expenses are rising at 3% annually but the COLA is set at 1% annually:
For many folks their actual expenses are rising faster than their COLA. (http://www.reuters.com/article/us-column-miller-colas-idUSKCN0IC1DP20141023)
The only way to know for sure is to take a look at your expenses for the last several years. Make sure you are comparing apples to apples. How much did your housing expenses increase (taxes, utilities, etc)? What about groceries? Car expenses (maintenance, license, insurance)? What about medical expenses?
Once you have these numbers for your expenses you can compare the rate of increase to the COLAs over the last several years. This will give you a good idea of what to expect.
The Combined Social Security Trust Funds are Running Dry
Another potential issue of concern for retirees is the Social Security “funding shortfall”, where taxes paid into the system are not enough to cover payments to retirees.
According to the summary report issued by the Social Security and Medicare Trustees for 2013 (https://www.ssa.gov/oact/TRSUM/2013/tr13summary.pdf):
“Neither Medicare nor Social Security can sustain projected long-run programs in full under currently scheduled financing, and legislative changes are necessary to avoid disruptive consequences for beneficiaries and taxpayers.”
The report mentions the strong likelihood of the depletion of the combined Social Security trust fund:
“After 2020, Treasury will redeem trust fund asset reserves to the extent that program cost exceeds tax revenue and interest earnings until depletion of total trust fund reserves in 2033, the same year projected in last year ’s Trustees Report. Thereafter, tax income would be sufficient to pay about three-quarters of scheduled benefits through 2087.”
The report goes on to offer several possible scenarios to address the issue of depleting funds including a tax increase, increasing the retirement age, and/or reducing benefits.
Social Security Benefits May be Less Than What You Need
So with Social Security retirement benefits we can conclude that the amount of money you can expect to receive will not fully cover your preretirement income. Indeed:
- The SSA states that Social Security benefits are not intended to cover all of your preretirement income
- Social Security benefits cover approximately 40% of preretirement income for the average worker, higher wage earners receive less
- Your benefits are calculated based on your wages over 35 years. If you do not work that long your benefits are reduced.
- You must wait until you are 66 to 67 (depending on when you were born) to receive full benefits. If you plan to retire earlier your benefits are reduced.
- For many folks the purchasing power of their benefits drops over time due to inflation and COLA not keeping up
- Social Security is facing funding problems which means it is possible that your benefits may be reduced, taxes may be raised, and/or the retirement age increased. All have happened previously.
It is clear that a person cannot rely solely on Social Security to provide for their needs and maintain a retirement lifestyle similar to what they enjoyed prior to retirement. In Part 3 of this series we will discuss ways to make up the difference. In Part 2 we explore what you can expect with Medicare.
To learn more about government retirement benefits see our article, Social Security and Medicare – A Good Deal?
Social Security retirement pamphlet https://www.ssa.gov/pubs/EN-05-10035.pdf
Social Security benefits estimator www.socialsecurity.gov/estimator
Taxes on Social Security benefits https://www.ssa.gov/planners/taxes.html
Cost of Living Adjustments to benefits https://www.ssa.gov/news/cola/
Expenses rising faster than COLA http://www.reuters.com/article/us-column-miller-colas-idUSKCN0IC1DP20141023
Social Security trust fund depletion https://www.ssa.gov/oact/TRSUM/2013/tr13summary.pdf