Planning for Retirement: What to Expect From Social Security

    by William Reichenstein

    Planning For Retirement: What To Expect From Social Security Splash image

    Retirement planning can be a daunting prospect, particularly for those approaching retirement age when the necessity of planning becomes much more obvious. Not only will you have a major change in sources of income that must be estimated, but those retirement income sources can have a major impact on the asset allocation decision for the family’s portfolio.

    Social Security and other retirement income streams are essentially bonds, and these bonds are usually a substantial part of a family’s total assets. To properly manage these assets, a family must understand the key features of its pension plans, including Social Security.

    This article will explain the basics of the Social Security program, which affects virtually every family. In particular, as you are approaching retirement you need to have some idea of how your decisions could affect the size of future benefits. We will explain some of the factors that will determine your level of Social Security retirement income, including the age you choose to start receiving benefits, outside income you may earn while receiving Social Security benefits, and the taxation of Social Security benefits.

    In future articles, we will discuss asset allocation during retirement and, in particular, how Social Security and other retirement plans may impact the management of a family’s total portfolio.

    Social Security Basics

    Individuals are entitled to Social Security benefits after earning 40 work credits; one work credit is earned for each quarter (three months) someone earns minimal income that is subject to Social Security taxes. Benefit payments may begin as early as age 62 or as late as age 70. The later one starts, the higher the monthly benefit payment. Once benefits begin, cost of living adjustments are made annually to ensure that payments will keep pace with inflation.

    Social Security sends out earnings statements to individuals a month or two before their birthday. What information do these statements convey?

    As an example, let’s consider Jack, a highly-paid executive, who a month or two before his 59th birthday receives the following Your Social Security Statement from the Social Security Administration:

    You have earned enough credits to qualify for benefits. At your current earnings rate:

    • If you stop working at age 62 your payment would be about $1,267/month;
    • If you continue working until your Full Retirement Age (65 and 10 months), your payment would be about $1,715/month;
    • If you continue working until age 70, your payment would be about $2,302/month.
    The statement presents the levels of projected monthly benefits in today’s dollars if Jack were to begin benefits at age 62, at his Full Retirement Age (FRA), or at age 70. However, it is important to understand that these projections assume he will continue to earn his current level of inflation-adjusted income (or, at least, the maximum income subject to Social Security taxes) until benefits begin.

    If Jack retires at age 62 and begins receiving benefits at age 62—which are two separate decisions—then he can expect an inflation-adjusted monthly income of $1,267 for the rest of his life. If he continues to work until Full Retirement Age and then retires and begins receiving payments, he would get $1,715 a month, and if he retires and begins receiving payments at age 70 the projected monthly income is $2,302.

    What does “Full Retirement Age” mean? Someone who begins benefits at Full Retirement Age receives full benefits. Someone who begins benefits before attaining Full Retirement Age receives reduced benefits. Someone who delays receiving Social Security benefits until after Full Retirement Age receives delayed retirement credits (DRC). In addition, benefits that are received before an individual reaches Full Retirement Age are subject to reduction if the individual continues working and receives earnings above specified limits (discussed in the next section).

    Full Retirement Age for individuals has gradually increased over the years. For someone born before 1938, Full Retirement Age is 65, while for those people born in 1960 or later it is 67.

    Table 1 presents Full Retirement Ages, as well as the adjustments to payments for someone who begins receiving payments before Full Retirement Age and someone who begins receiving payments after Full Retirement Age.



    As an example, for someone born in 1940, Full Retirement Age is 65 years and six months. If this individual starts to receive benefits at age 62, or three years and six months early, the monthly benefit would be 77½% of the Full Retirement Age benefit. On the other hand, if this individual were to continue working until age 70 and then start receiving benefits, the monthly benefit would be 131½% of the Full Retirement Age benefit.

    The Benefits

    Social Security benefits are based on a worker’s earned income that is subject to Social Security taxes. In addition, others may be entitled to benefits based on a worker’s earnings record, including a spouse, dependent children, parents (if over age 62 and dependents of the worker), and possibly a divorced spouse. A current spouse may receive up to 50% of a worker’s benefits. Dependent unmarried children under age 18 (or 19, if a full-time high-school student) are eligible for up to 50% of the level of benefits. However, there is a maximum family benefit based on earnings, which varies from 150% to 188% of monthly benefits.

    The projected benefit payments in Your Social Security Statement are based on detailed calculations. For family retirement planning, it is important to understand a few key features of the calculations. The monthly benefit payment is a portion of the worker’s average indexed monthly earnings (AIME) for the 35 years of highest earnings, where earnings for years before age 60 are indexed to reflect wage inflation. The maximum income for any year is equal to that year’s maximum income subject to Social Security taxes. This maximum income is $84,900 in 2002, but, even after adjustment for wage inflation, it was less than $40,000 before the early 1970s.

    AIME is converted to monthly income using a complicated formula that adds 90% of the first amount of average monthly earnings, 32% of the next amount of monthly earnings and 15% of additional amounts; the breaks for first, second and third amount of earnings vary by year of birth. For instance, an AIME of $3,000 converts to a primary insurance amount (PIA) of $1,381 for someone born in 1938. This formula ensures a higher coverage of Social Security benefits at lower income levels: Social Security payments may replace 60% of pre-retirement income for someone earning minimum wage, but only 25% of income for someone earning the maximum income subject to Social Security taxes.

    An understanding of the formulas is useful in decisions concerning how long to continue working. For instance, suppose someone is 60 with 35 years of earnings history and is considering retiring now or at age 65, but in either case he will begin receiving benefits at age 65. His decision to work five more years or retire today will likely have little effect on the size of his Social Security benefits.

    Reductions to Benefits

    Monthly Social Security benefits may be reduced or eliminated due to three factors. The first two factors directly reduce benefits, while the third—taxation—indirectly reduces benefits.

    The Earnings Test: The earnings test applies to individuals who begin receiving payments before reaching Full Retirement Age.

    In years before reaching Full Retirement Age, Social Security benefits are reduced by $1 for every $2 of earned income above $11,280 (in 2002). In the year someone reaches Full Retirement Age, benefits may be reduced by $1 for every $3 of earned income above $30,000 (in 2002). After reaching Full Retirement Age, individuals can receive full benefits with no limit on earnings.

    As an example, suppose Mary begins receiving Social Security benefits at age 62 in January 2002 and is entitled to $700 a month ($8,400 for the year). During the year, she earns $25,000, which is $13,720 over the $11,280 limit. Social Security would withhold $6,860—virtually all of her benefits—and she would only receive $1,540 in benefits.

    Rule-of-thumb: People with earned income exceeding the limit should seldom begin receiving Social Security before attaining Full Retirement Age.

    Let’s change the example. Suppose Mary is 64 at the beginning of the year, but reaches her Full Retirement Age in October 2002. She would receive $700 a month in benefits before the earnings test. She earns $48,000 during the year, including $36,000 from January through September. She would have $2,000 of benefits withheld ($1 for every $3 earned through September above the $30,000 limit). This equates to a reduction of about $222 of the $700 in monthly benefits for each month from January through September. Beginning in October when she attains Full Retirement Age, she would receive full benefits regardless of earnings.

    A third example illustrates a special rule that applies to the first year of retirement when someone retires before attaining Full Retirement Age. Suppose Luke works through September of his 63rd year and then retires and begins benefits in October. (This example differs from the second example because Mary attained Full Retirement Age while Luke has not.) Luke earns $50,000 through September, at which time he retires. He begins benefits in October and takes a part-time job that pays less than $940 a month, where $940 is the 2002 yearly income limit of $11,280 divided by 12. Even though his earnings through September substantially exceeded the annual limit, he would receive his Social Security benefits for October through December as long as he earns $940 or less in each month from October through December. If he earns $1 more than $940 in any month after September, he will lose all benefits for all three months. Beginning in 2003, only the yearly income limit will apply to him because he will be beyond his first year of retirement.

    The Earnings Test is based on earned income. It includes wages, salary, and self-employed income. It does not include interest income, dividends, capital gains, withdrawals from a 401(k), 403(b), traditional IRA, Keogh and other deductible pensions, or withdrawals from non-qualified tax-deferred annuities.

    Pensions From Work not Covered by Social Security: There are two parts to this reduction. The Windfall Elimination Provision applies to benefits based on the worker’s earnings record when he or she also receives pension benefits from an employer that does not withhold Social Security taxes (for example, certain federal, state, or local government agencies). The Government Pension Offset applies to spousal or widow(er)’s benefit.

    The Windfall Elimination Provision may reduce Social Security benefits for “double dippers”—individuals who receive retirement benefits from a retirement system other than Social Security. Suppose Nancy receives retirement benefits from the Texas teachers retirement system, which is not part of the Social Security system. In addition, she paid Social Security taxes on “substantial” earnings for 20 years or less. Her AIME would be reduced, with the amount of the reduction based on the number of years in which she had “substantial earnings” on which she paid Social Security taxes. [See SSA Publication No. 05-10045 for details, including definitions of “substantial” earnings, which vary year by year.]

    Similarly, the Government Pension Offset reduces or eliminates the amount of the spouse’s or widow(er)’s benefit by two-thirds of the amount of the government pension. [For further details, see “A Pension From Work Not Covered by Social Security,” SSA Pub no. 05-10045, and “Government Pension Offset,” SSA Pub no. 05-10007.]

    Taxation: Taxation is the third way Social Security benefits may be reduced. The Earnings Test, as we saw earlier, applies only to individuals below Full Retirement Age. However, the Income Test determines the taxation of Social Security benefits, and it applies to everyone.

    The Income Test is based on what’s known as “combined income,” which is the sum of adjusted gross income, plus non-taxable interest income earned, plus one-half of Social Security benefits. A single person with combined income between $25,000 and $34,000 would have to pay taxes on up to 50% of Social Security benefits. If combined income exceeds $34,000, up to 85% of Social Security benefits may be taxable. The same pattern applies to a couple filing jointly, but the income thresholds are $32,000 and $44,000. Couples filing separately who lived together automatically pay taxes on 85% of benefits.

    Consider a couple filing jointly with $45,000 of adjusted gross income, $2,000 of non-taxable municipal bond interest, and $18,000 of Social Security payments. Combined income is thus $56,000 ($45,000 + $2,000 + [½ × $18,000]) . The taxable portion of Social Security payments is the minimum of three amounts:

    • The first amount is the sum of 50% of income between $32,000 and $44,000 plus 85% of income above $44,000. In this example, it is $16,200 ([0.50 × $12,000] + [0.85 × $12,000]).
    • The second amount is 85% of Social Security benefits, which in this example is $15,300 ($18,000 × 0.85).
    • The third amount is the sum of one half the Social Security benefits plus 85% of the amount above $44,000. In this example, it is $19,200 ([0.50 × $18,000] + [0.85 × $12,000]).
    For this couple, the minimum of these three amounts is $15,300, so this couple must pay taxes on 85% of Social Security benefits. As this example shows, a couple need not be living in luxury before they have to pay taxes on 85% of benefits.

    For someone in the 30% tax bracket during retirement, taxes effectively reduce Social Security benefits by up to 25.5%, (0.85 × 0.30).


    This article explains factors that determine the levels of retirement income people are entitled to receive from Social Security. Each year, an individual receives his or her annual Your Social Security Statement, which projects levels of benefits at various ages. Although this is a useful projection of your Social Security benefits, it is important to understand that it assumes the individual will continue to earn his or her current real income until benefits begin.

    In addition, several factors can cause the aftertax value of actual benefits to be below the projected benefit levels:

    • The earnings test applies to individuals who begin benefits before attaining FRA. Annual earned income above relatively modest levels would reduce or even eliminate projected benefits. Consequently, individuals who intend to continue working should seldom begin benefits before attaining Full Retirement Age unless their future earned income will be limited.
    • The second factor affects individuals who receive pension benefits from work not covered by Social Security.
    • Taxes on Social Security benefits will also reduce the level of benefits, and they apply to all individuals. Singles and couples with more than modest levels of income will likely owe taxes on up to 85% of Social Security benefits.
    As with any large government program, exceptions exist. For additional details, see the Social Security Administration Web site at Another excellent description of the program is the TIAA-CREF pamphlet entitled “Making Sense of Social Security,” which is available at (or go to, click on Library on the right-hand side, and select “Making Sense of Social Security” from the Library Series).

    William Jennings, CFA, is an associate professor of finance at the U.S. Air Force Academy. William Reichenstein, CFA, holds the Pat and Thomas R. Powers Chair in Investment Management at Baylor University. The opinions expressed are those of the authors and are not necessarily those of the USAFA, the U.S. Air Force or any other federal agency.

    The authors may be reached via E-mail at and

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