Personal Finance — Understanding Social Security Income

Social Security is a welfare program in the USA. As with many things financial, it helps to understand the program in some detail to get the most out of it. When you finish reading, you should be able to determine when to start receiving your earned benefits in retirement.

Important: I am only discussing retirement benefits. Social Security also provides disability benefits, but that is beyond the scope of this article.

Some Basics

• Social Security is a welfare program for citizens and green card holders (see eligibility) of the United States. It’s designed to provide financial protection for retired and disabled Americans. You can find more details at the official site.
• You can create an account and sign in to get an idea of your earned benefits here.
• Employees pay a 6.2% tax rate on the first $168,000 (for 2024) of their income to fund Social Security. Employers match this tax rate, though you won’t see this detail on your paycheck. If you earn less than the base ($168k for 2024), you only pay the 6.2% rate on what you earned. If you earn more than that, you won’t pay any social security tax on the difference.
• To be eligible for social security benefits, you should have worked for at least 10 years. Note that you could be eligible for social security benefits as a surviving spouse, even if you never worked.
• The amount of social security you receive during retirement depends on two factors: the income earned during the best 35 years of your life and the age at which you start drawing your benefits.
• If you worked for 35 years or less, all those years will be used to compute the size of your social security payment. If you worked for more than 35 years, the best 35 years are used.

Monthly Benefits

Social Security pays out benefits monthly, and it adjusts this monthly payment every year to account for inflation. This is Cost of Living Adjustment (COLA). You can see a history of COLA adjustments here.

Now we get to the fun part – figuring out when you should start collecting your retirement benefits. As of 2024, you will receive full benefits when you start collecting at age 67. You can choose to collect earlier, starting from 62, or wait up to the age of 70. If you start earlier, your monthly payment will be lower than when you start at 67. If you start later, they will be higher.

What are the tradeoffs of starting earlier or later, compared to starting at the full retirement age of 67? Let’s find out.

Consider Longevity

Social Security benefits last until your death. If you started receiving benefits at age 70 and met an untimely death at 71, you have had a year’s worth of withdrawals. If you managed to live until 100, you would have received the same schedule of payments for a full 30 years. It pays to live longer 🙂

Here’s a chart showing the cumulative payments you would receive if you started at age 62 (blue line) or age 67 (green line), or age 70 (red line). The starting monthly payments are $2,418.30, $3,477.60, and $4,321.80 respectively. These numbers were taken from an actual benefits statement. A fixed percentage factor was applied to the numbers from the statement to conceal the original numbers. Also, a fixed 3.0% COLA adjustment was applied to account for inflation. In the real world COLA adjustment is influenced by inflation rate. We don’t know what the future holds, so we are assuming a fixed 3% rate for future years. That assumption doesn’t impact our analysis.

Some observations:

• If you started withdrawing at age 62 (blue line), the chart shows you would have received a cumulative total of $250,000 at age 69.
• If you started at age 67 (green line), you would have received the same cumulative total ($250,000) at about age 71.5.
• If you started at age 70 (red line), you would have received the same cumulative total at about 73.5.
• The chart only goes up to age 90 for brevity. The last crossover happened at age 86. After that, the red line continues to look even better by the year.

Line Crossovers

• The first crossover happens close to age 81, where the green line crosses the blue line. That is where your decision to start at age 67 starts to look better compared to age 62.
• The second crossover happens close to age 83, where the red line crosses over the blue line. That is where your decision to start at age 70 starts to look better compared to age 62.
• The third crossover happens close to age 85, where the red line crosses over the green line. That is where your decision to start at age 70 starts to look better compared to age 67.

Conclusions From Crossovers

• If you expect to live past 85 and you can afford it, consider waiting until age 70 to start your withdrawals.
• If you are eager to start your payments at the earliest opportunity, you can start at age 62. Use the chart to give you a rough idea of what you are leaving on the table if you happened to live past 85. If you need the income to fund your retirement, starting at age 62 is likely a better bargain than tapping into other savings such as withdrawing from your IRA accounts or selling assets that you otherwise would have kept.
• Waiting until age 67 is a good compromise. You will be able to start receiving benefits 3 years sooner than if you started at age 70. And the difference only starts to matter if you live past 90.

Assuming you don’t need Social Security payments to fund your retirement, is longevity the only factor to consider when deciding the starting point? No. Your monthly payments are higher the later you start. This implies that the US government is implicitly reinvesting what you didn’t withdraw by starting earlier and returning you a higher monthly payment if you started later.

Consider Returns

Let’s say you started at age 62 and invested all the payments yourself. What would the rate of return have to be to turn $2,418.30 at age 62 to $3,477.60 at age 67? You would need an annual return of about 7.5% to compound $2,418.30 into $3,477.60 in 5 years. Similarly, the return must be 8.7% to turn $2,418.30 into $4,321.80 in 8 years!

The rates of return mentioned above didn’t account for income taxes. Social Security payments are taxed by the Federal government and by some state governments. So, if you started at age 62 with the expectation of being able to grow that income faster than the government, your gross returns would have to be at least 10% and 11.5% respectively to account for income taxes.

Can you manage to return 10%+ year after year on these savings? You must take risks and spend some time and energy to consistently earn double digit returns. On the other hand, the government is guaranteeing you a higher risk-free return on monthly benefits while you enjoy your golden years.

Other Risks

So far, we have considered two primary factors – your longevity and your investment prowess. There are no guarantees, but you can come up with some reasonable guesses based on what you know about yourself.

The biggest risk we haven’t yet discussed is potential changes to the laws governing Social Security. In theory, US Congress could change the laws anytime to significantly change the benefits you receive. They could bump up the tax rates and the base amount, so more social security taxes are siphoned off from your paycheck. They could reduce the monthly payments. They may even cut wasteful spending and increase your monthly payments! Okay, that last one was a joke.

Should you worry about potential loss of income from Social Security? You paid all these years into it and one day they could disappear! I’ve been hearing these concerns since I started working. That was 30+ years ago. Thankfully, nothing has changed even as the US and global economies and financial systems experienced multiple shocks in those years. As shown here, about 20% of Americans receive Social Security benefits. Making a drastic change that impacts that high a percentage of the population is not easy. If for some reason something changes, we are likely to have enough notice to reevaluate and adjust.

We recommend making your informed opinion based on what we know today. Change is constant and the future is uncertain. That applies to every aspect of our lives.

Social Security as an Annuity

A good mental model is to think of Social Security benefits as an annuity operated by the US government. Between you and your employer, you are paying into the fund (currently 12.4% on a base of up to about $168,000 2024) every year during your working life. For the monthly numbers we used above, a total of about $370,000 was collected as Social Security tax over a 35-year period.

So, for most people, they are merely earning an annuity like income from what they paid into the system. We didn’t have a choice. We had to pay these taxes, by law. So don’t let anyone tell you that you are receiving a handout from the government.

Conclusion

We gave you some facts and perspectives to help make important decisions about your Social Security benefits. It helps to have other sources of income to supplement the monthly Social Security payments. That gives you flexibility to maximize your benefits. Lastly, work with facts at hand and deal with changes as they happen.

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