If you’re just stopping by for the first time, this is a class in a series of classes over the next few months which will culminate in the development of a complete financial plan. Stop by HERE for a complete list of classes currently available and HERE for more information about the website.
Class Objectives: To learn how Social Security and Medicare tie into retirement planning.
Prerequisites: RE401: Calculating Retirement Needs
Assignment: Calculate your Social Security benefits under different scenarios using the Social Security Online Calculator.
There’s a misconception that Social Security is becoming so underfunded that it likely won’t even be around by the time my generation retires. I’ve often seen people completely leave it out of their projection for future retirement altogether because of the uncertainty around it.
However, according to the most recent analysis by the Social Security Board of Trustees, this is far from true. They estimate that by 2034 Social Security as it currently stands will only be able to cover about 75% of scheduled benefits but that rate would be sustainable through at least 2090.
Realistically, it’s doubtful that the government would allow an essential program that provides 34% of the income of the elderly population to deplete in this way. More likely, there will be a combination of adjustments to the program, tax increases and minor benefit cuts to compensate for the shortfall.
What Exactly is the Purpose of Social Security?
Social Security is a government-run program that benefits people who are retired or disabled or families of those that are disabled or deceased. By having this program in place, it helps to ensure the financial stability of those that couldn’t provide for themselves otherwise. Everyone’s money goes into a joint pool of money and those that are eligible for benefits receive that money. This class will only focus on the retirement portion of Social Security.
Essentially, right now you are funding the benefits for current retirees who are no longer paying into the system but did in the past. When you receive benefits in the future, that money will be received from money provided by those still working and paying those taxes.
Currently, the Social Security rate is 6.2% of employment income capped at $127,200 for 2017. We talked about how to calculate Social Security withholding in mini-class TX302: Payroll Withholding Tax Essentials.
Just to give you an idea, the average benefit for retired workers is currently a little over $1,300 per month. The absolute maximum amount someone can receive for Social Security is currently $2,639 per month (assuming they paid in the maximum social security tax for 35 years).
Getting Your Social Security Statement Online
In the past, Social Security statements were mailed annually to everyone 21 years and older. However, now you have to create an online account to see your statement, which you can quickly generate online (it’s better in my opinion!).
To get your statement, go to Social Security’s MyAccount website. Click on the button that says “Sign In or Create an Account”.
If this is your first time setting up an account, you’ll enter your personal information in the screen shown below and then be required to verify some additional information.
Once your account is setup, you’ll see a quick overview of your benefits and recent earnings. Click on the tab “Estimated Benefits” to get more in-depth information that you can use to add to your retirement plan.
If you’ve paid enough into the Social Security system to qualify for benefits, your screen will show something similar to the following:
We talked briefly about Social Security disability benefits in class IN205: Disability Insurance Basics. The survivor benefits are applicable to your analysis in considering how much life insurance you need (class IN204: Life Insurance Basics). So, here we will solely be focusing on the Retirement portion of Social Security benefits.
Requirements for Social Security Benefits
In order to qualify to receive Social Security benefits, you are required to obtain a certain number of work credits. You can earn up to 4 credits each year, with one credit being given for $1,260 in employment earnings ($5,040 would be the minimum required to get a full 4 credits for a year). You need 40 credits to get retirement benefits, which would be 10 years of earning at least $5,040.
It is important to note that there are different credit requirements to qualify for retirement, disability and survivor benefits under the SS system.
Most people fairly easily qualify for retirement benefits, but the monthly benefit amount varies based on your earnings history. The following 3-step process is used to calculate your benefits:
- All previous years earnings are converted to today’s dollars.
- The average of the 35 years of highest earnings is divided by 420 (35 years x 12 months) to get the Average Indexed Monthly Earnings (AIME). If you don’t have 35 years, 0’s will be factored into the formula as well for those years less than 35.
- A benefit formula is applied to step 2 earnings (AIME) to get the Primary Insurance Amount (PIA). This is the amount that will be received at full retirement age (currently 67). This benefit formula consists of 3 different percentages, one based on 90% the AIME from $0-$885, the next based on 32% of AIME from $885-$5,336 and the last one based on 15% from $5,336 and up.
Note that the earnings that they will use for Social Security in step 2 above are the same as those used to calculate Social Security taxes, which are capped each year ($127,200 for 2017). So, high-income earners have a cap on the amount of Social Security earnings that they will receive.
Tools for Estimating Social Security Benefits
If you are near retirement age for Social Security purposes, you will want a more advanced tool (and/or professional advice), but I’ve found the online calculator to be more than sufficient to run estimates for my future projections.
To start, go to the Online Calculator on the Social Security website. If you scroll down, the beginning of the inputs will look like this:
The required inputs are:
- Date of birth
- Age at retirement (note when looking at estimated benefits that if you take retirement before full retirement age of 67 for those born after 1960 they will be reduced, but if you wait to take retirement benefits they will be increased by each year you wait up to age 70)
- Whether you want to see the benefits in today’s dollars of future dollars (choose today’s dollars because that’s how we have been calculating retirement needs)
- Annual earnings (you can get historical earnings from your online account)
- Earnings in 2016 (you should have your W-2 by now!)
- Earnings in 2017 and later (use an average of income you expect to earn until you stop working, but be sure not to include amounts over the taxable limit which is currently 127,200)
The outputs you will be looking for are the “Retirement insured status” (insured meaning you have met the 40 credit requirement) and “Your monthly retirement benefit” amount.
This calculator is especially useful if you plan to have significant changes in your future income from what is shown in your current statement (which generally assumes you will be at the same level of earning in the future as now) or if you plan to retire early without working a full 35 years, which will result in a lower benefit.
How To Use Social Security in Your Retirement Plan
After these calculations, you’ll want to go back to your calculation of your retirement needs and make adjustments as necessary to include the amount you think you’ll receive each month for Social Security (in today’s dollars).
I believe that it is appropriate to include Social Security in your retirement plan and that using 75% of your currently stated projected benefits will be a good conservative estimate. This amount should be included in “other income” when creating your projected retirement budget which was presented in class RE401: Calculating Retirement Needs.
If you are married, you need to know a little bit about how Social Security benefits coordinate. You can either collect Social Security benefits based on your own earnings or receive 50% of your spouse’s retirement benefits as long as you meet certain requirements. There are many planning strategies related to coordinating benefits.
As a note, one recommendation is that Social Security is only meant to replace 40% of your income. If you are relying on it to replace your entire income, you will want to rethink your retirement plan. Specifically, you should:
- Contribute as much as you can to your 401(k) and/or other qualified retirement plan
- Open a traditional or Roth IRA
- Invest in a traditional brokerage account once other retirement options are maxed out
How Medicare Fits In Your Retirement Plan
Because healthcare is one of the most significant pieces of your retirement plan, I also wanted to briefly discuss the Medicare system.
Similarly to Social Security, you are paying for your future Medicare coverage now through your payroll tax contributions. Currently, the Medicare FICA tax rate is 1.45% of all employment income. In addition, those individuals earning more than $200,000 (or $250,000 for couples) pay an additional .9% Medicare tax. We talked about how to calculate Medicare tax withholding in mini-class TX302: Payroll Withholding Tax Essentials.
If you are insured for Social Security benefits (as per requirements above), you will be able to participate in Medicare. You are eligible for Medicare when you reach age 65, whether you are still employed or not.
Medicare is not the same as the more comprehensive insurance plan that you likely (hopefully) currently have. There are multiple parts, some which you may or may not decide to participate in when you retire.
- Medicare Part A covers hospital, home health, and hospice care and is fully covered without an additional premium for most retirees. There is a $1,316 deductible that applies for 2017.
- Medicare Part B is insurance that covers doctor and outpatient services. The standard premium is $134/month in 2017, but varies for some participants. The deductible is currently $183 with 20% coinsurance for most services.
- Medicare Part C are also referred to as Medicare Advantage Plans and is an alternative offered by private insurance companies (more expensive and with different rules).
- Medicare Part D is prescription drug coverage. There are a variety of premiums depending on the specific plan you choose. There are deductibles and out-of-pocket limits that apply as well.
In addition, there are policies called Medigap plans that coordinate with original Medicare to cover the “gaps” in deductibles, coinsurance and copays.
If you’re concerned about healthcare in retirement, you should consider doing the following:
- Learn about whether a long-term care insurance plan might be a good choice for you
- Start contributing now to an HSA account if you have a high-deductible health plan that qualifies you for one.
This concludes the series of retirement classes so, at this point, you should have a pretty good plan for reaching your retirement goals.
Social Security is not a full solution for your retirement needs, but it will help to provide some stable income that you can use to fund your expenses. You’ve likely paid into it for many years and you should fully expect to reap some benefits, although the specifics may be uncertain right now.
EXAMPLE: THE SMITH FAMILY
Jim Smith discovers that his estimated retirement benefit is $1,900 per month based on his past historical earnings and future expected earnings at $60,000 per year. Mary Smith finds her estimated retirement benefits to be $1,120 per month based on her past and current earnings. Their combined total benefits would be $3,020 per month.
They previously estimated a total of $1,500 in Social Security benefits when calculating their retirement needs. For this purpose, they should revise their estimate to include $3,020 x 75% or $2,265 per month. This will result in the following updated calculation, based on a retirement age of 65:
Your homework assignment is to estimate your future Social Security benefits and the impact they’ll have on your future retirement needs.
- IMPROVING -Create an online account at the Social Security website and look up your expected retirement benefits.
- INVESTED – Use the online calculator to calculate your expected retirement benefits based on your historical and future expected earnings.
- UNSTOPPABLE – Determine your expected retirement benefits under several different scenarios using the online calculator on the Social Security website.