|Social Security Benefits Seem Anything But Secure|
As might be expected, some taxpayers attempt to play games with these tradeoffs. While "earnings" reduce benefits, unearned income doesn't-a client could receive $1 million in investment income at age 65 and still collect full Social Security benefits. "Some strategies are legitimate," Buie says. "Clients who are self-employed might defer billing from age 69 to age 70. However, there are also some people who try to manipulate the system improperly." Business owners receive a great deal of scrutiny in this regard. Some attempt to maximize benefits while in their sixties by cutting their salaries yet taking money from their company via "loan proceeds," "rents," "dividends" or a huge "expense account." Still others try to shift their compensation to a spouse. As a result, Social Security frequently makes special demands upon "retired" owners of family businesses. Such individuals may have to furnish corporate records and complete a Self-Employment Corporate Officer Questionnaire, in order to receive retirement benefits. In essence, the Social Security Administration will look hard at how much work a client actually performs and how he's compensated. If there's a suspicion of excess earnings, he may be called in for an interview to prove that he's truly retired. Nevertheless, there are appropriate techniques for re-casting income yet staying within the letter and the spirit of the law. Such preparation might begin a few years ahead of time, with the creation of a special class of dividend-paying preferred stock, owned by Joe Business Owner. If Joe actually works less, he might take a reduced salary, in his sixties, yet still receive substantial income from dividends. (An S corporation election can ease the problem of double taxation for his company.) Retirement plans can be pushed to the max, in order to provide more unearned income. Joe might even sell some of his shares to the company each year, if he needs still more income. As long as he is the majority shareholder, he'll be able to make decisions as an owner rather than as a full-time, highly paid executive. Deferred compensation is another tactic that can work for business owners or corporate employees as well. For calculation of Social Security benefits, deferred compensation is counted when earned, not when received. Therefore, if a client has been in a deferred compensation plan prior to age 62, that client can receive payments from 62 to 69 without losing benefits. On the other hand, deferring income from 62 to 69 to age 70-plus won't help because the income will count as current earnings, offsetting Social Security benefits.
Extra planning may be needed for clients who retire with unexercised stock options.
"When a client exercises a nonqualified stock option," Law says, "that shows up
on a W-2 form, so Social Security thinks income has been earned. Actually, this
type of income enjoys an exemption so it won't affect Social Security benefits,
but planners need to be prepared to help clients provide the required paperwork
in order to keep their benefits." Just to make planning for Social Security even
more intricate, taxes on Social Security benefits may need to be considered. "You
start out by calculating 'provisional income,' which is the total of adjusted gross
income, tax-exempt interest income and one-half of your annual Social Security benefits,"
says Sidney Kess, an attorney and CPA in New York. "If provisional income is well
over $50,000, 85% of Social Security benefits likely will be taxed. If provisional
income is under $25,000, no benefits will be taxed. In the middle, some techniques
to reduce provisional income may reduce taxes substantially." Planners' Strategies
What are some of those techniques? Working less, which also can reduce lost benefits
due to "excessive income." Focusing on growth rather than income in an investment
portfolio. Investing in deferred annuities. Tapping lines of credit when cash is
needed. "If you're withdrawing from an IRA or liquidating appreciated investments
for retirement income," Kess says, "you might increase sales and withdrawals one
year, biting the tax bullet, and build up enough funds so you can minimize those
activities the next year, reducing provisional income." Such concerns may be most
important to clients who expect moderate incomes (say, $25,000 to $50,000) in retirement.
But another issue concerns virtually all clients, even the wealthiest: How should
future Social Security benefits be factored in to investment strategies?
In 1998, while the average Social Security benefit is more than $9,000 per year,
retiree who has always earned the maximum amount subject to Social Security benefits
will receive more than $16,000. Some retirees receive as much as $22,000, thanks
to delayed retirement credits. A married couple might receive twice as much, if
both spouses had careers; assuming one spouse provided most of the income, the other
spouse is entitled to 50% of that spouse's benefit, calculated before any delayed
retirement credits. (Divorcees and widows are entitled to benefits after 10 years
of marriage.) Thus, it's not unusual for upper-income retired couples to be collecting
more than $20,000 per year in Social Security benefits today. Even assuming modest
cost-of-living adjustments in the future, a couple planning to retire in 10 years
could receive $25,000 to $30,000 a year or even more. What's more, that's a lifetime
income (after one spouse dies, the other will collect the survivor's full benefit,
including any delayed retirement credit). Under present law, this lifetime annuity
is fully indexed to inflation and partially tax-exempt.
In other words, Social Security benefits are hardly insignificant: A client would
need $500,000 in 6% Treasuries to earn $30,000 per year. How should this future
income stream be factored into retirement planning? "When we work with older clients,
we project that Social Security benefits will be 100% taxable," Buie says, "and
we project increases in annual benefits at one-half the inflation rate rather than
the full rate. The longer the time until a client will begin receiving benefits,
the greater the difference this adjustment will make. When it comes to clients 35
or younger, we just ignore Social Security. The system might change dramatically
in the next 35 years." For Buie's clients who are older than 35, a discounted, fully
taxable Social Security benefit is included in projected retirement income. "If
we project that a client will need $6,000 a month in retirement, and Social Security
will provide $2,000 per month, then the other $4,000 has to come from somewhere.
So we develop a strategy aimed at building up enough of a fund to generate enough
income to bridge the gap."
Is it fair to say that $2,000 per month from Social Security is the equivalent
of $400,000 in bonds and adjust a client's portfolio accordingly, shortening the
fixed-income side and devoting more assets to equities? "That's the type of the
thing I'll do with a military or a corporate pension," Buie says. "I'm more skeptical
about Social Security." In practice, though, the result winds up being about the
same: Buie says her younger clients tend to be fully invested in equities while
even the older ones have at least 50% in stocks.
Richard Vodra, another planner in Falls Church, does equate anticipated Social Security benefits to a lump-sum invested in securities. "I assume 100% taxability of benefits, at a 25% average tax, rather than a marginal tax-rate. Then I capitalize this income stream at 2%, the after-inflation yield on municipal bonds, and factor in the number of years the client can expect to receive these benefits. For a client receiving $1,500 per month from Social Security, the present value might be about $340,000." This number is presented to Vodra's clients to give them a better idea of their actual financial picture. "Clients who are not super rich have to save money for their retirement," he says. "Generally, they have to save an amount equal to seven times their income, which is difficult enough. If you tell those clients that they're going to live until age 98 and they shouldn't count on Social Security, these clients might need to save 10 times their income. Encouraging over-saving may be good for asset managers but not necessarily for their clients."
Although various methods may be used, anticipated future Social Security benefits should be factored in to investment plans, especially as clients approach and reach retirement. Condon says that Social Security benefits are "a given, like air. You start with Social Security and retirement planning goes on from there." Near-term, at least, this breath of air can keep cash flowing and provide clients with the assurance they may need to maintain their exposure to equities. FP
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