How the Coming Social Security Changes May Impact Your Income and Retirement



January 2020 marked the 83rd anniversary of the first Social Security payment made in the United States. Signed by President Franklin Delano Roosevelt on Aug. 14, 1935, the Social Security Act was passed to provide an economic safety net for the elderly through a systematized retirement savings plan into which workers would contribute to their retirement via payroll tax withholdings. Prescient on Roosevelt's part as the 401(k) plan wasn't introduced until 1978.


The initial problem with FDR's retirement plan was that it didn't account for inflation. The cost of goods and services were rising each year while benefit payments remained stagnant. This was corrected in 1975 when legislation was enacted to increase Social Security benefits based on the Consumer Price Index, or CPI. And since then, benefits have risen on average 3.6% per year with some years seeing an increase as high as 14.3%.



Fast forward to today and the Social Security trust is dwindling as people are living longer and taking more from the pot. Additionally, low interest rates have dampened returns on U.S. Treasuries, the primary investment vehicle the government uses to invest your social security dollars, making it difficult for the pot to keep up with distributions.


Those paying into social security are concerned their taxes may rise or worse, that the pot will run out before they retire, leaving them to rely solely on their own savings and investments. Some nearing or in retirement are considering filing for Social Security but are unsure when they should pull the trigger. And those currently collecting Social Security are worried their benefits may decrease, or at the very least remain unchanged and be eroded by inflation.


Regardless of who wins the 2020 election, here is a list, by category, of the most important changes coming to Social Security in 2021.


CATEGORY 1: STILL WORKING OR HAVEN'T FILED FOR SOCIAL SECURITY YET



Workers and their employers each pay 6.2% of the employee's gross wages up to a limit (known as the "wage base") toward Social Security. The Social Security Administration (SSA) will be increasing the maximum wage base from $137,700 annually in 2020 to $142,800 in 2021. This means if you currently make $142,800 or more, expect to see your net paycheck marginally decrease by roughly $26 per month.


Another change forthcoming in 2021 is an increase to the full retirement age (FRA), or year in which you're entitled to receive 100% of your benefits. Those born in 1959 will have to wait until they're 66 and 10 months old to collect the full amount of their benefits, while those born in 1960 or later will have to wait until age 67.


According to a recent Forbes article, 96% of retirees don't file for Social Security at the optimal time. Now, I could argue that "optimal time" is an arbitrary term with regards to filing Social Security as everyone's financial situation is different. Some people need the income sooner rather than later, while others have the assets to support their retirement and can afford to delay.


Regardless, it pays to be informed and understand how your benefits may be affected, especially if you're someone nearing FRA and haven't filed for Social Security.


CATEGORY 2: STILL WORKING AND RECEIVING SOCIAL SECURITY



If you're one of the many retirees receiving social security while maintaining a full- or part-time job, you may see a slight increase in your benefits in 2021 depending on how much you make. The SSA reduces benefits by $1 for every $2 of earned income above a certain amount for those who haven't attained FRA. This amount will increase from $18,240 annually in 2020 to $18,960 in 2021, giving you a little more leeway to earn without having your benefits cut.


Example 1: You expect to earn $20,960 in wages for the year 2021, $2,000 over the limit noted above. Accordingly, your expected Social Security benefits for 2021 would be reduced by $1,000 ($1 for every $2 of earnings above $18,960).


Those who will attain FRA in 2021, meaning you'll be 66 and 2 months old, will have a higher earnings limit of $50,520 annually, up from $48,600 in 2020. Workers in this category will see their benefits reduced by $1 for every $3 earned above the earnings limit.


Example 2: You'll be turning 66 years young in 2021 and reaching FRA. You're collecting Social Security benefits and plan to earn $56,520 next year, $6,000 over the limit. Under this scenario, your benefits would be reduced by $2,000 ($1 for every $3 of earnings above $56,250).


The good news is that once you reach your FRA, you can earn as much as you want without having a reduction in benefits.


CATEGORY 3: NOT WORKING AND RECEIVING SOCIAL SECURITY BENEFITS


Those receiving Social Security who've decided to hang up their cleats can expect a 1.3% increase in benefits for 2021, which equates to an average $20 per month boost for the average person collecting Social Security. Though this cost of living adjustment (COLA) is less than in years past, any positive increase should be a welcome sigh of relief for retirees considering that inflation has remained in check this year due to the global pandemic's impact on the economy.


But with more income comes potentially more taxes. Currently, a couple filing a joint tax return with a combined annual income between $32,000 and $44,000 will have to pay tax on up to 1/2 of their Social Security benefits. However, couples with combined income exceeding $44,000 will pay tax on up to 85% of their benefits.


Granted, a 1.3% increase in benefits alone won't drastically boost your tax liability, though other ancillary changes to your income such as an increase in capital gains resulting from changes made to your investments may have a meaningful impact on the percentage your benefits are taxed.


For example, assume the following income figures for a married couple filing jointly in 2020:


Scenario 1

Taxable IRA distributions - $25,000

Long-term capital gains on your investments - $5,000

Dividend Income - $5,000

Non-taxable interest income - $3,000

Social security income - $25,000


Assuming a marginal tax rate of 12%, this scenario would result in approximately 46% of your Social Security benefits being subject to taxation.


But what if you or your advisor made changes to your investment portfolio resulting in an increase in short and long-term capital gains? Then your scenario could look like this:


Scenario 2

Taxable IRA distributions - $25,000

Short-term capital gains on your investments - $2,000

Long-term capital gains on your investments - $10,000

Dividend Income - $5,000

Non-taxable interest income - $3,000

Social security income - $25,325 (Adjusted for 1.3% increase)


Under this scenario, the $2,000 short-term capital gain and additional $5,000 in long-term gains, coupled with a 1.3% cost of living adjustment would result in 70% of your Social Security benefits being taxable. In other words, you'd pay more than $700 in taxes under Scenario 2 compared to Scenario 1.


Please note that these figures are generic and were run using a tax planning calculator and should not be construed as tax advice. Further, it's important to recognize "combined income" is different than "taxable income." The SSA defines combined income as your adjusted gross income (AGI) + 1/2 of your SS benefits + non-taxable interest income (think muni bonds).


As you can see, this stuff gets really confusing, really quickly! Consult your tax or financial professional for questions pertaining to your personal situation.


WHAT DOES THIS MEAN FOR YOU?



Guaranteed retirement payments are hard to come by these days. With high operating costs and an anemic interest rate environment, pension plans have become something of a myth with only a few large, well-established companies having the financial wherewithal to offer to their employees.


That leaves most retirees to fend for themselves and live off some combination of their savings and Social Security, the latter of which can be a confounding topic for investors to grapple with.


If you're in CATEGORY 1 and still working/haven't filed for benefits yet, it's never too early to start crunching the numbers. Even if you haven't attained FRA, you may have enough saved to retire now and elect to file for benefits early. Sure, you'll lose out on higher benefit payments in the future had you waited until FRA, but you'll also be collecting income during that time and the trade-off might be advantageous enough for you to take action now.


Retirees in CATEGORY 2 who are collecting benefits and earning income can benefit from some quick and easy financial planning. For example, if you make $30/hour in retirement and know you'll reach the $18,960 earnings limit on July 1, 2021 (and won't attain FRA), you're in a sense rewarded with a 50% pay cut for the remaining six months given your benefits are reduced by $1 for every $2 earned. Or if you're turning FRA say, on March 1, 2021 and will make substantially more than the allotted $50,520, you may consider waiting until then to start working (assuming you can) so your benefits won't be affected. This kind of "back of the napkin" planning may help you decide if working more is really worth it, assuming of course you don't need to.


And last but not least, CATEGORY 3 retirees should pay close attention to their income excluding Social Security as even minor changes in their investment strategy can result in unwanted capital gains that could increase the amount of Social Security being subject to taxation, which in turn leads to higher taxes. If you're unsure where you stand, ask to sit down with your advisor or tax professional well before the end of the year to determine what actions, if any, should be taken.

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