Mark Miller, Morningstar2
The bipartisan budget deal signed into law last week by President Obama jolted some near-retirement couples–and the retirement-planning world–by closing a loophole in Social Security law that a growing number of married couples were using to substantially increase their benefits.
The law makes changes in two Social Security claiming maneuvers–“file-and-suspend” and “restricted claims”–that have become the foundation of online-optimization services offered by financial-services firms and companies offering Social Security advice.
In the long run, closing the loopholes will simplify the range of Social Security claiming choices available to couples. But for now, the clampdown has created as many questions as it answers–about the closed loopholes, but also about the Social Security claiming techniques that remain available to married couples in the wake of the new legislation. Herewith are answers to the key questions I’m hearing from readers.
Q: What’s all the commotion about, anyway?
A: Good question, since both of these maneuvers were obscure and not very well known to the public until the past few years. Roughly 100,000 workers and spouses have used the strategies, according to Social Security Administration (SSA) estimates. The techniques exploit a loophole created when the Senior Citizens Freedom to Work Act of 2000 became law.
The law had its origins in Newt Gingrich’s Contract With America, which proposed repealing rules discouraging seniors from working. The Freedom to Work Act repealed the retirement-earnings test for workers who had reached full retirement age (FRA). Today, the earnings test reduces annual benefits–only for those below FRA–by $1 for every full $2 the beneficiary earns over the annual exempt amount (currently $15,720), although the withheld benefits are later returned.
The main intent of the law was to give people incentives to work longer by allowing them to work and receive full Social Security benefits after they reached FRA. Several years after its passage, some clever financial advisors noticed that the language opened the door for the file-and-suspend and restricted-claim maneuvers.
When used together, restricted applications and file-and-suspend are used to boost a couple’s lifetime Social Security benefits by allowing them to accumulate delayed retirement credits while also collecting a benefit.
Q: What’s a delayed retirement credit?
A: Social Security benefits are calculated using a formula called the primary insurance amount, or PIA. Although you can claim benefits as young as 62, by waiting until your full retirement age (currently 66), you’ll receive 100% of PIA; every 12 months that you delay beyond that point–until age 70–tacks on an additional 8%. Conversely, if you wanted to file for benefits at 62–the first age of eligibility–your PIA would be reduced by 25%, and that reduction would continue for the rest of your life.
Q: How did the benefit-boosting loophole work?
A: The first maneuver is called file-and-suspend. The spouse with a higher benefit–typically the husband–files for his benefits at full retirement age and then suspends them, continuing to accrue delayed retirement credits. That sets the stage for the lower-benefit spouse to file for her spousal benefit (equal to 50% of the husband’s). If her full benefit is greater than the spousal benefit, she had the additional option–under the loophole–to “restrict” the application to a spousal benefit only. The restricted application effectively delays the filing for her own benefit, allowing it also to continue earning delayed retirement credits.
Q: How much in additional benefits could married couples get using these claiming techniques?
A: That all depends on the couples’ PIA, but it can typically range from $35,000 to a little more than $60,000 in today’s dollars, according to Michael Kitces of Maryland-based Pinnacle Advisory Group and author of the Nerd’s Eye View Blog.
Q: What exactly is changing under the clampdown?
A: The budget act prohibits new file-and-suspend claiming, starting six months after the legislation’s enactment (President Obama signed the law on Nov. 2). And it disallows restricted applications for anyone who has not reached age 62 by the end of calendar-year 2015.
Q: It sounds like some people will still be able to squeeze in on this before the door shuts?
A: Yes. Since file-and-suspend is only available to workers who have reached full retirement age, it remains available to workers who either already have turned 66, or will do so within the next six months. Couples who already have executed the strategy are unaffected by the new law.
Also, there likely will be a “long tail” of this type of filing stretching through 2019. The restricted application is available only for people who have turned 62 by the end of calendar-year 2015, which means an end to the practice of filing for a spousal benefit at your full retirement age and shifting to a (larger) individual benefit later on.
“So long as you are 62 by the end of this year, you can do a restricted application whenever you get to full retirement age–if you’re 62 this year, you won’t do it until 2019,” says Kitces.
He offers the example of a 67-year-old husband with a spouse currently age 64. “He files and suspends his benefit now, before the window closes, but nothing further happens for two years. Then, when his wife turns 66, she can go in and do a restricted application–take the spousal benefit now and convert to her own larger benefit at 70.”
Q: Does this clampdown mean workers can’t gain any advantages by coordinating their Social Security strategies?
A: Not at all! Couples will still be able to benefit by considering a range of options. Should one or the other spouse start benefits early, should both delay, or should both file early? Most often, couples will benefit if the higher-benefit spouse delays filing to earn delayed credits.
Social Security’s filing rules are designed to be actuarially “fair,” which means the credits for delayed filing (and penalties for early filing) should give us all roughly the same lifetme income–at least, according to the actuarial tables. You get about 8% less for every year you file early (starting at age 62), and the same increase for every year you wait until age 70–the last year for which additional credits are available.
Higher-income people tend to live longer, so they stand to benefit from delayed filing. The most recent mortality tables from the Society of Actuaries show that average life expectancy for a 65-year-old male is 3.16 years longer in the highest-income quartile than in the lowest band; for women, the gap is 1.52 years.
Kitces notes that the 8% delayed retirement credit is mispriced in today’s market, because it was created in the early 1980s, when mortality projections were lower and interest rates higher. As a result, delaying is like buying a very-high-return bond or annuity–free of risk. “It’s mispriced in today’s market,” he says.
Q: How can I determine the best strategy for myself and my spouse?
A: Both spouses should begin by checking their annual Social Security statements, which estimate benefits at age 62, full retirement age, and age 70. This gives you a starting point for massaging the numbers. Although the SSA no longer mails a statement every year, you can download your statement at any time if you have a (free) MySSA account at the SSA website.
A growing number of financial planners are familiar with the Social Security rules, as are advisory services offered to workers by many 401(K) plan sponsors. Optimization tools are available online and one-on-one for free or for a small fee.
E*TRADE Financial Corporation and its affiliates do not provide tax advice, and you always should consult your own tax adviser regarding your personal circumstances before taking any action that may have tax consequences.
@ Copyright 2016 Morningstar, Inc. All rights reserved.