Social Security And Early Retirement

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For many, the monthly social security check is a welcome sight.  Part of the social contract for ages, it helps pay rent and grocery bills, put some gas in the Cadillac, and provide for the occasional trip to Florida.  With all of the press about the underfunding of the Social Security trust, it still takes in more in employment taxes than it pays out, and is part of retirement planning for the majority of future retirees

Like many retirees (early and otherwise), we paid no Social Security tax in 2013 (and don’t plan to ever again*.)  This raised a great question on the recent post where we shared our 2013 taxes.

“The one downside to not paying social security tax going forward is that your payout when you retire will be lower than a person paying as they continue to work….am I correct about this? If so, then the loss of a “annuity product for life” can be a major problem.”

Let’s see if this is a major problem, or even a problem at all.

To be eligible to receive future Social Security payments, an individual needs to earn 40 credits.  For most people this means working for a decade, which is a convenient number since it is also possible to save enough to retire in just 10 years.  The Social Security payout is determined by a formula based on the average of your 35 highest income working years.  If you work less than 35 years, your payout will be lower.  Seems reasonable

The Social Security Administration provides a (not very good) calculator to estimate your future benefit.  You just enter your date of birth, your earnings history, and an estimate of your future earnings, and the calculator provides a benefits estimate.

Based on our working history and no additional taxes paid past 2012, if we elected to receive Social Security benefits at the age of 62, we would receive $1312 a month in “Today’s dollars.”  If instead of early retirement and world travel, we had elected to work until age 62 , we would be eligible to increase that monthly check by $617.

Work another 25 years to get an extra $617 a month?!  Does it seem worth it?  Let’s investigate

The 4% rule states we would need a portfolio worth $185k to provide $617 in monthly spending.  By comparison to the $363k that would be paid in taxes during an additional 25 years of employment, $185k looks pretty reasonable

Our 2013 spending of $33.5k can be sustained by a portfolio of $836k.  Savings an additional $185k certainly would have taken less than 25 years.

Clearly Social Security isn’t the most efficient option for funding a retirement.  What other options do we have?  Since Social Security is a complex instrument, it is somewhat difficult to completely estimate alternatives.  No direct replacement exists in the private market, but we can get similar if not equivalent coverage by purchasing:

  • An inflation-adjusted annuity with survivor benefits
  • Disability insurance
  • Term life insurance (to buy an annuity for our descendents upon an untimely death)

An annuity is a contract with an insurance company.  In exchange for an up-front payment, they will manage your funds and provide a monthly income for life.  In exchange, they get to keep the remainder of your money when you die.  With a higher cost, the annuity can provide survivor benefits, which provides income to a surviving spouse

Most insurance companies want you to speak to an agent to get a quote for one of these, but one online calculator (UK based) estimated an inflation adjusted annuity with 50% spousal benefit with payments starting at age 62, would cost $298k.  Since this is 25 years from now, adjusting for present value allows for a much more affordable price of between $70k (Do it yourself investment at 6% return) and $125k (insurance company invests for you at the “safe rate” of 3.62%.)

Disability Insurance provides income if for some reason a person becomes disabled and can’t work in the same capacity.  Usually this is to provide income during recovery or to allow training for a new vocation.  Social Security benefits are fairly generous in this case, sometimes providing income for life.  The closest equivalent would be disability insurance with a 2 year payout, for which I found an online quote for a $2k/month policy for $40 a month ($480/year.)

In the event of an untimely death, a life insurance policy provides financial support for our family.  A $150k term life insurance policy could be used to purchase an immediate annuity at a cost of $43 a month ($516 per year.)

While these solutions aren’t an exact equivalent of what Social Security offers, it comes close.  And while Congress could change Social Security at any time (for better or worse), these contracts are a known entity.

We could either work for another 25 years or (as closely as possible) substitute private market solutions with a total cost of about $83 a month and a bit of savings for an annuity.

The closer one comes to financial independence, the less necessary these insurance options are.  Without a job, there is really no need to have disability insurance, and with a sizable nest egg there is really no need to have life insurance.  For that matter, the annuity is starting to look like a bad deal.

So while it is true that working fewer years will provide for a lower Social Security payout, it looks like Social Security isn’t such a great deal in the first place.  Better to focus on saving and use private market solutions until savings grow to sufficient size to become independent.  Consistent with our general attitude that it is better to self insure when you have the means to do so, we will neither work 25 more years nor purchase private insurance.

* Odds are that in 25 years we will also elect to not receive Social Security.  Having more income won’t make us any happier, and since Social Security is considered Earned Income it would mess with our tax planning

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20 Responses to Social Security And Early Retirement

  1. We’re in a similar position of not really caring about making our SS as high as possible. Since I retired at 33, I only have 10 great years of earnings and another 6-7 years of wishy washy lower earnings. I’ll get around $1000-1300/month in today’s dollars depending on when I start collecting (and so will Mrs. RoG). Would I work another 25 years to max out my SS earnings history just to receive an additional $600-700/month? Hell no! That would be a paltry rate of return.

    The progressive nature of the SS payment calculation means those with higher lifetime earnings get a proportionally lower payout versus what they put in. In other words, doubling or tripling your lifetime SS earnings history won’t increase your monthly check by 2-3x.

    Like you, we have focused on building wealth in our investment accounts that will support our lifestyle. Hey, if SS is there in another 30-40 years, great! If not, no big deal (for us at least).

  2. Insourcelife says:

    Social Security was designed for your average American that saves an average of 10% or less during their 35+ working years. You guys are way outside of that demographic so your analysis makes perfect sense.

  3. Joe S. says:

    Well– thank you Team Curry Cracker, for responding to my comment by making a whole new post….I am honored and am truly glad that you explained what looks to me as benefits of “financial Independence” as opposed to working to achieve the best Social Security payout. My basic plan is to retire in about twelve years while also collecting an old school pension (Rare these days -I know) at around 55…I know old, but hey not I just started this “extreme retirement” savings thing just this last coule of years….

    Thanks again,

    Joe S.

    • Thank you Joe for the great question. I’d been meaning to write about SS for awhile and your question was great motivation

      12 years will go by in a flash, and you’ll be out of the rat race well ahead of the “normal” schedule. Who knows, maybe even sooner.

  4. Spoonman says:

    I have a very cynical attitude toward SS. In my view, it’s just one of those things that I have to pay into right now that I will probably never see.

    By the time we pull the plug in a few months I don’t think I will have accrued the necessary number of points. But even if I was eligible to receive benefits, I wouldn’t make plans with SS in mind. Ever since I started my journey toward FI I never took SS into account, and I’m glad I haven’t. I feel the situation with SS is rather fragile, the fund may not survive in its current form for another 30 years. (I have to admit that my fears are mostly irrational, but I think there’s some truth in what I fear).

    In any case, our dividend machine is almost fully operational now and will continue to dish out inflation-beating income for decades to come, so I don’t worry about SS much.

    • It’s hard to not be cynical. As a society we could provide a much better safety net at a much lower price

      I just put on my “abundance mentality” hat and remember that I was lucky enough to not need any of that money and was able to make a contribution to those less fortunate

  5. jlcollinsnh says:

    Another great financial post from my favorite travel blog! :)

    Consider too that for the financially successful, as the readers of your blog are destined to be, the tax code is set so as to recapture a chunk of the benefits you’ll receive.

    If your SS benefit is your only income you will in most cases receive it tax free.

    But if you start adding additional income from side projects (such as a blog) or withdrawals from your IRAs (and these become mandatory at age 70) your benefits quickly become subject to income tax.

    All the more reason to follow the early retirement path and step away from the tread mill after 10 or 15 years.

    • Haha, thanks Jim. With all of this free time I just can’t seem to help thinking about my favorite hobby :)

      The tax rules on Social Security seem a bit punitive.
      “You were able to save some money? No SS for you.” – Uncle Sam
      It seems to have the effective of turning SS into just a safety net, albeit a very inefficient one

      • I also want to say, I like your post on SS
        http://jlcollinsnh.com/2013/01/29/social-security-how-secure-and-when-to-take-it/

        It is a great read, particularly for people interested in the history or deciding if/when to start collecting SS checks

      • Cheddar Stacker says:

        Maybe I’m incorrect, but I’ve always thought of SS as nothing more than a safety net for the less fortunate. The name itself even implies it right? -“Social Security”. We’ve just gotten to a point where most of our nation is less fortunate, even if for many of them it’s by their own poor life decisions.

        You are correct, the tax rules for SS are punitive, but I think it’s intentional. It’s not intended to allow those already on the gravy train to get a bigger ladle, even though they’ve paid their share into the system.

        Kudos to you if you elect to not receive the benefits. I’ve often thought of doing the same if I truly don’t need it.

        Just for fun though after reading another great post by the “Curry-Cracker-er” I played around with the tax caster to see what impact a $20K social security benefit would have on a tax return like yours. You would still pay no tax on $70K of L-T gains, but you would pay tax if you had any other ordinary income.

        • Go Curry Cracker says:

          Check out Jim Collins’ post on the history of SS, its a pretty interesting read

          Yeah, $20k income from Social Security by itself won’t impact taxes much. It only becomes a problem if you are doing ROTH IRA Conversions, as that income is considered Earned. But maybe by the time we reach 62 we will be done with that process

          Thanks again Chedder Stacker(-er) :) for your support, I really appreciate it!

  6. baughman says:

    Awesome and timely post. I’m about to start making some decent money as a professor and many of the schools I’m looking at don’t collect social security taxes due to the presence of a state run pension that the university pays into. Not paying into social security saves 7.65% per paycheck (or twice that if considering employer contribution) on the fist 125k of income. It’s a non-trivial amount. Just last night I was doing the math to quantify the net benefit of going to a school such as one of these. My back of the envelop calculations indicated that this was a huge benefit (especially if the employer can afford to pay you 7.65% more as a result of its forgone obligatory social security payment which is admittedly unlikely to be the case). Additionally, social security benefits can’t be exercised early as a 401(k) => Traditional IRA => Slow modest annual conversion to Roth IRA can be.

    After looking through your blog and mad fiendests, my 401k / traditional IRAs / tax free realization of capital gains due to low labor income will fund the early phases of my retirement, whereas unused HSA balances will be used to supplement the above when I’m old.

  7. I liked your analysis and was thinking about posting about this for one of my downsides to ER, but the way the benefit is calculated and the mess that SS will be in by the time we claim, it is not really that big of a deal, as you pointed out. However, there is one bit of low-hanging fruit that should be mentioned. The formula to calculate the benefit for 2014 is: 0.9(816)+0.32(4917-816)+0.15(‘the rest of the average/35 yr amount paid in to SS’). If you can get total payments into the system to average out and fill up the middle 32% bracket, or be certain to cover the whole 0.9 bracket in the future, you really have gotten maximum bang for the buck. The calculation brackets go up each year, so even if you hit the SS limit (6.2 x 2 x 117k) for 10 years, there’s no way to fill up 0.32, but with 20-25 years, you have higher contribution and are closer to the inflated calculation brackets to be used. I might still post on this, since it’s too complicated to condense into a comment and I should whip out a calculator, but I’m taking it easy this weekend :) Why stress thinking about ER during time off!
    Mainly wanted to point out that you will probably get somewhat lower payments than you state above, that was just ‘today dollar’ estimates with the current brackets and we’re 20+ years away, but ER’s aren’t depending on SS anyway right!

    • I definitely think social security payments in 25 years will be lower than today’s estimate, the system has to be “saved” somehow. This will be through a combination of lower payouts, increased “full entitlement age”, and (most likely) removing the ceiling on annual contributions

      In conclusion, working longer to increase SS payouts is a bad deal

    • So, Steve, what are you saying the ideal FICA taxable income is for 2014 if somebody wanted to notch the credit but contribute no more above 0.9 or 0.32 brackets?

      • Yes, it seems as if you’ll get a nice return on the first $4,917 of earned income. At a minimum the first $816 has a great return if one has the option of only paying FICA on that each year in early retirement.

        Ha, and here I am replying to past me I just notice. At least my interests are consistent even if my memory isn’t.

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