Introduction
Deciding when to file for Social Security benefits is a critical financial decision that significantly impacts an individual's retirement planning. Many people wait until reaching their full retirement age to start receiving Social Security benefits, not wishing to reduce their monthly benefits, and some will even delay until age 70 to maximize their monthly income. However, an alternative strategy has been gaining attention: filing for Social Security benefits early and strategically saving or investing the money.
This approach, which allows individuals to start receiving benefits as early as age 62, opens the door to various financial planning opportunities. It offers the flexibility to augment retirement savings, diversify income sources, and potentially capitalize on investment growth. But, like any financial strategy, it also comes with its complexities and potential drawbacks.
In this article, we will explore three distinct scenarios where early Social Security filing could be advantageous: a working individual boosting their 401k contributions, a retired person investing in bonds, and a non-working spouse channeling funds into a Roth IRA and after-tax savings. Each scenario illustrates how early Social Security benefits can be leveraged in different life and income situations.
Yet, it's crucial to navigate this decision with a full understanding of the implications. Navigating the decision to file for Social Security benefits early requires a nuanced understanding of both the opportunities and challenges. Our exploration aims to provide insights and guidance to help you make an informed choice that aligns with your unique financial goals and retirement plans.
Section 1: Benefits of Early Filing and Saving
The strategy of filing for Social Security benefits early and saving or investing the funds can potentially be an effective way to enhance your financial security in retirement. Below, we examine three scenarios where individuals choose this path, each with distinct goals and outcomes.
Scenario 1: For the Working Individual: Enhancing 401k Contributions
Scenario Description:
A working individual, full retirement age, opts to file for Social Security benefits even though they still have employment income. Instead of using their Social Security benefits for immediate expenses, they channel the benefits into their 401k plan.
Benefits:
Accelerated Retirement Savings: The additional contributions to the 401k can significantly increase the retirement corpus due to compounding interest over time.
Tax Advantages: Since only 85% of Social Security benefits are subject to federal income tax and 401k contributions are generally made pre-tax, this will reduce the individual's taxable income and providing immediate tax benefits.
Example Calculation:
Consider an individual who receives $2,000 monthly from Social Security and contributes this amount to their 401k. They will likely reduce their taxable income by $3,600. Also, assuming this person files for Social Security at 67, and is able to achieve an average annual return of 6%, this strategy could result in ~$80,000 of additional savings by the time they reach the age of 70.
Scenario 2: For the Retired Individual: Investing in Bonds
Scenario Description:
In this scenario, a retired person without earned income chooses to file for Social Security benefits early. This retiree doesn't need the benefits for their living expenses, so instead of delaying benefits to further increase their income, they opt to take the income and invest. For our example, their choice of investments will be an investment grade bond portfolio yielding 6%.
Benefits:
Enhanced of Savings: If the retiree currently does not have any significant emergency savings, this could provide a way for the person to build up a source to cover unexpected expenses.
Enhance Estate: Since Social Security income benefits cannot have any beneficiaries, putting the dollars in an account and then earning interest can be a good way to enhance the amount of dollars that are available for inheritance.
Case Study:
A retired individual receives $2,200 monthly from Social Security and invests this sum in bonds. The 6% annual return on these bonds translates into a steady growth of the invested capital, if the investor is able to do this for a total of 10 years, the account would be worth ~$368,000.
Scenario 3 For Couples with One Working Spouse: Roth and After-Tax Savings
Scenario Description:
In this scenario we have a married couple. Here, one spouse is not earning a salary and files for Social Security benefits early. The couple then invests these benefits into a Roth IRA and after-tax savings accounts for use once the other spouse retires.
Benefits:
Tax-Free Growth in Roth IRA: Unlike traditional IRAs, Roth IRAs offer tax-free growth and withdrawals, providing a significant tax advantage in retirement. Since one spouse is working, the retired spouse is able to save money into a Roth IRA based upon their spouses earned income.
Diversification of Income Sources: By investing in both Roth IRAs and after-tax savings, the couple diversifies their retirement income, reducing tax risk and improving financial stability.
Analysis:
This approach allows this couple to build a more tax-efficient retirement plan. For instance, if the retired spouses monthly Social Security benefit is $1,000 per month, they can save $8,000 of it into a Roth IRA and the rest can be put into a brokerage account. It could mean as much as ~$4,000 in tax free income from the Roth IRA and ~$1,300 of tax free income from Municipal bonds in a brokerage account. This would be accomplished by savings occurring over an 8 year period and earning 6% with a 5% distribution and a 3.5% yield compounded until retirement respectively.
These scenarios demonstrate how early Social Security filing, when paired with thoughtful investment strategies, can enhance retirement readiness. However, it's important to tailor these strategies to individual circumstances, considering factors such as risk tolerance, investment horizon, and overall retirement goals.
Section 2: Potential Pitfalls of Early Social Security Filing
While early Social Security filing can offer unique opportunities for financial planning, it's essential to be aware of the potential drawbacks. This section outlines key pitfalls that individuals should consider before deciding to file early.
Pitfall #1: Loss of Guaranteed 8% Annual Increase
Explanation:
Delaying Social Security benefits beyond the full retirement age can result in an 8% guaranteed increase in benefits for each year of delay, up until age 70. Filing early means forgoing this significant growth potential.
Impact Analysis:
For example, if an individual's full retirement benefit at age 67 is $1,500 per month, delaying benefits until age 70 would increase their monthly benefit to approximately $1,860. This increase, over the long term, could result in substantially higher total benefits, especially for those with a longer lifespan.
Pitfall #2: Reduced Impact of COLA Adjustments
Description:
Social Security benefits are adjusted for inflation through Cost-of-Living Adjustments (COLA). These adjustments are percentage increases based on the benefit amount.
Comparative Analysis:
The impact of COLA on a smaller early benefit is less than it would be on a larger delayed benefit. For instance, a 2% COLA on a $1,200 early benefit increases the monthly amount by $24, whereas the same COLA on a $1,500 delayed benefit results in a $30 increase. Over time, this difference can accumulate, leading to a significant disparity in total benefits received.
Pitfall #3: Earnings Limitation for Early Filers
Outline:
Individuals who file for Social Security benefits before reaching full retirement age and continue to work may be subject to an earnings limit. Exceeding this limit can result in a temporary reduction in benefits. An individual filing early while earning a high income may have their benefits reduced. For example, in 2024, the earnings limit was $22,320, and for every $2 earned over this limit, $1 was withheld from benefits
Example:
If a worker is 62 and files for a benefit of $2,000/month and their salary is $62,320, they are $40,000 above the limit. Using the 1 for 2 calculation this means that this worker is ineligible to receive $20,000 of their Social Security Benefits for the year, which is 5/6ths of their total benefits.
These pitfalls highlight the importance of careful consideration and planning when deciding to file for Social Security benefits early. The decision should be made in the context of one’s overall financial picture, longevity expectations, and retirement goals. Professional financial advice can be invaluable in navigating these complexities.
Conclusion: Weighing the Decision to File for Social Security Early
Deciding to file for Social Security benefits early is a significant choice that hinges on balancing immediate financial needs with long-term retirement goals. This strategy offers the opportunity to grow retirement savings through investments like 401k contributions, bonds, or Roth IRAs. However, it's crucial to consider the trade-offs, such as reduced monthly benefits and the impact of early filing on future cost-of-living adjustments and earnings limits.
Ultimately, the decision should be tailored to individual circumstances, factoring in financial stability, retirement plans, and life expectancy. It's important to approach this choice with a clear understanding of both the immediate and long-term implications for your retirement security. Seeking advice from financial advisors can be beneficial in navigating this complex decision, ensuring a choice that aligns with your overall financial well-being.
