Timely Topics 

Courtesy of Caves & Associates  2/4/2008

Dear Clients and Friends,

Our occasional publication of Timely Topics follows; contents are:

1.      A primer and guide to maximizing Social Security retirement benefits.

2.      Making annual gifts within the gift tax exclusion.

3.      “Kiddie Tax” extension further reduces income splitting opportunities.

4.      2007 IRA contribution deadline is 4/15/08.

Timely Topics is general in nature and should not be relied upon for specific strategy without consulting us and/or other pertinent professionals.  Also, the following Partial Guide to Social Security is so-called because its brevity prevents scratching too far beneath the surface; the U.S. Social Security system is extremely complex, and system representatives should be consulted before final decisions.

1. A Partial Guide to Social Security Retirement Benefits  

As Social Security has evolved over the years, it has become the paramount financial safety net for soon-to-be retirees.  Unfortunately, it includes some of the most complicated decisions to be made in later life.  While about half of workers simply begin collecting benefits on their 62^nd birthday, many are realizing that a variety of factors can disconcert what appears to be a straightforward decision.  Taxes, spousal earnings and age, health, and even life plans are all variables to consider when contemplating the most strategic and beneficial time to collect Social Security benefits.  To put it simply, no one should let Social Security “just happen.”

Benefit Amounts Depend on Your Age at Starting Date

According to the Employee Benefit Research Institute, 30% of workers believe that they will be eligible for unreduced Social Security benefits at age 65, while 21% believe they are eligible for unreduced benefits before age 65.  The problem?  Both of these assumptions are incorrect.  The truth is that anyone may begin receiving benefits at 62, but they will be penalized until they reach full retirement age, which is in fact 66 for most people.  A breakdown of age versus reduction in benefits is as follows: Assuming your full retirement age is 66, and you file for benefits at 62, your monthly check will be reduced by about 25% from your full benefit; filing at 63 reduces it by about 20%; filing at 64 reduces it by about 13.3%; and at 65, the reduction is about 6.7%.  It is crucial to be aware that these reductions are permanent; they do not phase-out as you reach or pass your full retirement age.  It can be concluded then, that the longer one waits to file for benefits, the better, unless your actual years collecting benefits in retirement is significantly less than your actuarial life expectancy (i.e., you don’t live as long as you’re “supposed to”).

There is an exception to the general guidance against taking benefits early.  In the event of a spouse’s premature death, as early as age 60 (or younger if disabled or caring for a minor), the widow or widower may claim a reduced survivor’s benefit, based on the deceased’s earnings history.  At full retirement age, the widow or widower may opt to switch to his or her own retirement benefit without any reduction in payment.  In this way, taking a survivors benefit will allow you to collect benefits early without any penalization to your own benefits at age 66.

Relation to Earned Income

If you are collecting a salary as well as Social Security benefits, filing early results in another reduction as well – a consequence of the Social Security Administration’s “earnings test.”  Regardless of exact age, receiving benefits as well as income before reaching full retirement age results in a reduction of $1 for every $2 earned above the annual limit.  In 2008, the limit is $13,560.  During the year you reach your full retirement age, the deduction is decreased to $1 for every $3 earned above a higher limit ($36,120 in 2008).  Finally, starting with the month you reach full retirement age, the deductions end.  It is especially important to note that one should not stop working or limit earnings in order to merely avoid the earnings test.  Once you reach full retirement age, the Social Security agency recalculates your future benefits in order to compensate for any loss due to the earnings test.  In most cases, therefore, the test is really a delay in benefits, rather than a “tax” or forfeiture.

When to Start (Let the Complications Begin)

Before “taking the plunge,” consider that a variety of factors, such as longer life spans and the collapse of traditional pension plans, prompts experts to recommend waiting until your full retirement age (or later) to collect benefits.  In fact, if you were born in or after 1943, waiting past your full retirement age to collect benefits would increase them by about 8% per year.  You get your largest possible benefit at age 70, at which the payout would be 32% greater.  

At Caves & Associates, we generally agree with the experts.  We are more concerned with clients outliving their nest egg, in which case they’ll want the maximum Social Security payments.  We’re less concerned with leaving some Social Security benefits on the table in the event of delayed commencement of payments combined with clients’ premature death because this situation does not entail any undue financial hardship for the clients (though it does imply a reduced estate for heirs, which we can tolerate).

Decisions regarding spousal benefits can be quite complicated and require planning for future contingencies.  In a typical marital situation, the husband is somewhat older and probably has been the primary breadwinner.  He may have benefited from a high salary and have a longer earnings history because his wife interrupted her career to raise their children.  A very important rule regarding benefit calculation is that a married person, in this case the wife, collects Social Security based on her husband’s earnings record when her own benefit wouldn’t equal or exceed 50% of his.  However, starting age is still a factor.  If the wife claims early spousal benefits at age 62, relying on her husband’s higher earnings record, she receives 35% of her husband’s full benefit.  Waiting until full retirement age provides her with 50% of her husband’s benefit.  Among the many “wrinkles” regarding spousal benefits, it is noteworthy that the wife cannot claim spousal benefits until her husband files for benefits of his own.  This rule is a major obstacle when a higher earning husband is considerably younger than his wife.  Finally, if the husband chooses to receive Social Security before full retirement age, his wife’s spousal benefit would nonetheless be based on his entitled amount at 66.

A real concern is that taking early Social Security may cap a surviving spouse’s payout and diminish it by tens of thousands of dollars.  A surviving spouse past full retirement age is entitled to the larger of the two spouses’ benefits, either his or hers, but not both.  In this case, if the deceased spouse began receiving Social Security benefits at an early age, the widow or widower with a low earnings record of their own will then fall heir permanently to the reduced payout.

Because of the rules regarding spousal benefits, a married retiree, especially a man, in poor health should probably delay benefit commencement notwithstanding the expectation of premature death and the temptation to begin Social Security as early as possible.  If the spouse is the wife, she likely has a long life expectancy (women outlive men by about seven years according to actuarial tables and by much longer if the husband has health issues).  Over that expected long period surviving him, she will be much better off having her benefit based on his unreduced amount had he waited to start benefits.

A way in which couples who both have good earnings records can take full advantage of Social Security benefits over their lifetimes is for wives to claim benefits at or near the earliest age permissible (62) and for husbands to delay filing until age 70.  However, four years is quite a long time to wait to receive his benefits.  The following scenario provides a framework for couples of the same age to strategically avoid waiting and still receive a generous benefit at age 70: George and Martha, if they wait until their full retirement age of 66, expect a benefit of $2,000 a month and $1,000 a month, respectively.  Martha files for a reduced benefit on her own at age 63, and receives $800 a month (see above for the reference to a 20% reduction at age 63).  George, at age 66, files for just a spousal benefit, based on Martha’s earnings.  He would get $500 a month as Martha’s spouse.  Then, at age 70, George applies for benefits based on his earnings history.  With the “delayed retirement credit” (the additional dollars one receives for waiting until age 70 to claim Social Security), George’s benefit would be 32% higher, or $2,640 a month.  Social Security would stop George’s spousal benefit of $500 a month because he’s entitled to the $2,640, based on his own earnings at age 70.  Again, for this to work, George must wait until his full retirement age or later to file for a spousal benefit.  In this way, George maximizes their combined benefits and doesn’t have to wait four years beyond his full retirement age to receive a paycheck.  It is important to remember that this situation assumes George and Martha are the same age.

In this example, George and Martha will have foregone benefits of approximately $47,500 through age 69, which they would have received had both begun receiving benefits at age 66.  But at age 70, their annual benefits would be $5,280 higher under the strategy described in the preceding paragraph.  This suggests a breakeven in 9 years, or at about age 79, an age they are both likely to attain.  Moreover, if one does not, the survivor will have a benefit which is almost $7,700 more per year ($2,640 per month versus $2,000).  If Martha lives well into her 80’s or even her 90’s, as many women do, she and George will have wisely adopted a strategy providing her considerable “longevity insurance.”  (All the figures above ignore Social Security’s annual cost of living adjustments to benefit amounts).

Fund Operation and Long-Term Social Security Solvency

The biggest misunderstanding about Social Security is that your particular tax dollars are being set aside for you.  The fact of the matter is Social Security is largely a pay-as-you-go system, in which your tax dollars are used to pay current benefits.  In other words, the Social Security taxes you pay now benefit current retirees, and when it comes time for you to collect benefits, they will be funded by existing workers’ taxes.  

With this in mind, a significant concern for potential Social Security beneficiaries is that the system will go “broke” or “bankrupt” in the future.  While it is true that the coming decades will present a growing strain on Social Security, the bankruptcy prediction is a myth.  The Social Security Administration identified three important dates regarding the health of the program in its annual report to Congress this year.  Beginning in 2017, the Social Security Administration will be paying out more in benefits that it collects in revenue.  Next, in 2027, Social Security will have to supplement payouts with the principal in its trust fund, or savings account, to meet its monthly obligations.  Finally, in 2041, the trust fund will be exhausted, at which point the agency will be able to pay only about 75% of promised benefits.  Beneficiaries will receive overall benefits worth about 25% less than current rules call for, which is not exactly satisfying, but the system will remain in existence. 

There is some evidence that suggests older workers are remaining in the work force or rejoining it in greater numbers. If this is true, and the trend persists, it could provide a marginal cushion for the coming burdens on Social Security.  There is, of course, no telling what baby boomers will actually do in retirement.

Information Sources

Several sources are available as tools to aid in the decision making process and overall education about Social Security:

1.      www.ssa.gov: The Social Security Administration’s website features a number of calculators, extensive lists of frequently asked questions, access to forms and publications, and the ability to perform several tasks online (including filing for Social Security).

2.      “Social Security Benefits Handbook” www.socialsecuritybenefitshandbook.com: Authored by Stanley A. Tomkiel III, a New York lawyer.

3.      www.analyzenow.com: Features a number of helpful articles about the best age to file for benefits.

4.      “Ask Mary Jane” www.ncpssm.org/maryjane: Email a question to Mary Jane Yarrington, a senior policy analyst for a Washington advocacy group, The National Committee to Protect Social Security and Medicare.

5.      “Rethinking Social Security Claiming in a 401(k) World”: A report discussing filing for benefits and possible strategies for doing so.  It was authored by James Mahaney and Peter Carlson, retirement specialists at Prudential Financial, Inc.  It can be found at www.pensionresearchcouncil.org under “Working Papers” and 2007.

2. Using the $12,000/Year Gift Tax Exclusion

You can give away as much as $12,000 this year to anyone you want – and to as many people as you wish – without having to worry about any tax considerations.  You can make these gifts to family members, friends, or complete strangers.  Even better, there’s no total dollar limit on how much you can give away each year, as long as you do it in slices of $12,000.

A husband and wife each can make use of this provision, which means they jointly can give as much as $24,000 this year to each recipient.

This estate-planning tool isn’t the same as a tax “deduction.”  You can’t deduct any gifts unless you itemize your deductions and unless you make those gifts to qualified charitable organizations.  Family members and friends don’t count as charities.  This provision can’t be found anywhere on the federal tax form.  You aren’t supposed to report these gifts.

Annual gifting within the annual gift exclusion is the simplest and least risky technique to reduce your potential exposure to estate taxes if, as expected, the estate tax is not repealed by 2011 and beyond.  It is also the cheapest technique in the sense that it requires the least input or service by financial and/or legal advisors.  Cash always makes a great gift, but securities with the potential for high future appreciation are also a very good choice.  In most cases, gifts other than to charities of already highly appreciated securities are not recommended.

Of course, the donor must make sure not to jeopardize their own long run financial security by overuse of gifting.

3. Kiddie Tax Extended to Age 24

In May of 2007, Congress passed and the President signed The Small Business and Work Opportunity Act.  One of the changes made by the Act was to extend from age 18 to age 24 the period during which a child’s unearned income is taxed at the same marginal rate at which his parents’ income is taxed.  There is an exception for the first $1,700 of unearned income and any earned income, such as from summer jobs, which is taxed at the child’s own rate.  The extension to age 24 is limited to those circumstances where the child is a full-time student.  If a child over the age of 18 is not a full-time student, then his unearned income is taxed at his own marginal rate.  Prior to 2006, the special kiddie tax rules applied only through age 13.  In 2006, they were extended from 13 to 17. 

This change, which was effective last year, further diminishes the benefit of income splitting transactions among family members.  It effectively eliminates the advisability of establishing custodial accounts for minors to achieve income splitting.  The dispersion of income producing assets among family members can be attractive because the maximum federal income tax rate of 35% is not reached for an individual taxpayer until his taxable income reaches $350,000.  Thus, absent the kiddie tax provisions, considerable tax savings can be achieved by a family through the transfer of income producing assets to children, who would most often pay a lower rate of tax on the income produced by those assets than would have been paid by the parents.  The transfer of income producing assets can still be beneficial where the children are over 24 or over 18 and out of school.

4. 2007 IRA Contribution Deadline is 4/15/08

Congress is again raising the limits, and IRA contributions should be of interest to all taxpayers who have earned income at least equal to the limits.  Please note income from investments, Social Security, and pensions does not constitute earned income.  The allowable contribution to an IRA attributable to 2007 is $4,000 for anyone under 50 years of age and $5,000 for those over 50 as of the last day of the calendar year.  Accordingly, for a married couple the 2007 contribution limits total $8,000 - $10,000, depending on age.  These single and married limits are high enough to make a considerable difference over time in the rate of after-tax wealth accumulation for all but the wealthiest U.S. taxpayers (i.e., not a big enough impact for the really wealthy).  What’s more, these limits increase in 2008 to $5,000 for under 50, $6,000 for over 50, and thus $10,000-$12,000 for marrieds.  There are complicated rules limiting ROTH IRA contributions and the deductibility (but not the allowability) of traditional IRA contributions.  Nonetheless, even non-deductible contributions of $10,000 to traditional IRA’s repeated year after year can be valuable for enhanced wealth accumulation, especially for younger people, because of the long-term tax deferral respecting earnings attributable to the contributions.  It is also important to note that a non-working spouse may qualify for a deductible IRA contribution depending on the other spouse’s company-sponsored retirement plan participation status and the level of family income.  Your tax preparer is usually the best source for guidance regarding IRA contributions as each individual case differs. 

In summary, the annual IRA contribution is a perishable commodity: once the deadline passes, you are out of luck for 2007.