The latest FEDZONE article: “Beware of the Hazards and Pitfalls of Taking a Social Security Lump-Sum Payout”
Edward A. Zurndorfer
The FEDZONE column author recently received a question from an individual concerning when he should start taking his monthly Social Security retirement benefits. Because his question is a frequently asked question among individuals who are eligible to receive monthly Social Security retirement benefits, the question and answer are presented and discussed in this FEDZONE column.
First, some background information: The individual (to be called Francis that is not his real name) asking the question was born in November 1955. His “full retirement age” (FRA) (for Social Security retirement purposes) is age 66 years and 2 months, which Francis reached in January 2022. Francis is a federal employee under FERS and intends to retire from federal service on June 30, 2022. Francis’ specific question is when he should start receiving his Social Security retirement benefits. He stated that while he does not have any need for the Social Security monthly income at this time, that if he elected to start receiving his Social Security monthly retirement benefit at this time, he could make use of the monthly benefit by investing the money or using the monthly income to pay down his mortgage. His question was whether to go ahead and apply for his first Social Security check for July 2022 (the month after he retires from federal service) or maybe he should have started receiving his Social Security monthly retirement benefit in January 2022 when he reached his FRA.
Francis in fact was confused. He had a recent telephone conversation with a Social Security Administration representative. The Social Security representative told Francis that it made no difference when he initially claimed his Social Security – January 2022 or July 2022. With either claiming date, Francis’ monthly retirement benefit will be the same amount. How can that be? To explain how that can be, it is important to discuss “delay retirement credits” (DRCs) and how DRCs can affect the decision concerning when an individual should start taking his or her Social Security retirement monthly benefit.
Background Information on Delayed Retirement Credits
Individuals who are “fully insured” (that is, who have accumulated and earned at least 40 quarters of coverage or credits of Social Security) can elect to receive their monthly Social Security retirement benefit starting as early as age 62. But by starting to receive their Social Security monthly benefit at age 62, their monthly benefit will be permanently reduced. The individual can claim their monthly benefit at any time starting at age 62, but the closer the individual is to his or her FRA when he or she starts receiving his or her monthly retirement benefit, the less reduction in the monthly retirement benefit. If the individual elects to start receiving his or her monthly retirement benefit the month he or she becomes FRA, there is no reduction.
If an individual elects to further delay to start receiving his or her Social Security retirement benefit past his or her FRA, there will be a permanent increase in monthly benefits. In particular, for every year an individual waits to start receiving his or her monthly benefit past his or her FRA, the individual’s monthly benefit increases by 8 percent per year. These are called delayed retirement credits or DRCs. The DRCs apply until an individual becomes age 70. After reaching age 70, no DRCs apply.
While financial advisors talk about DRCs as getting a boost in Social Security retirement benefits of 8 percent per year up to age 70, the DRC is actually applied monthly (2/3 of 1 percent DRC per month). Francis’ waiting 6 months until July 2022 to start receiving his Social Security retirement benefit should therefore permanently boost Francis’ monthly payment by 4 percent (6 months times 2/3 of 1 percent per month equals 4 percent). Why then did the Social Security representative tell Francis that his monthly retirement benefit would be the same whether he applied for his Social Security monthly retirement benefit to start in January 2022 or to start in July 2022? To answer this question, it is important to discuss some of the nuances associated with an individual’s delaying the start of Social Security monthly retirement benefits past his or her FRA.
No doubt there is an advantage for an individual to claim his or her Social Security retirement benefit after the individual has reached his or her FRA. But there are also some lesser-known misunderstood rules that apply. One of the lesser-known rules is when an individual claims his or her monthly benefit after reaching his or her FRA, for every month past the month the individual becomes FRA the individual elects to delay the start of his or her Social Security monthly retirement benefit, the Social Security Administration will inform them know they are eligible to receive a lump sum payment equal to the Social Security monthly payments that the individual would have received had the individual elected to start receiving the monthly benefit in the month he or she became FRA.
The problem is that Social Security representatives often neglect to explain the consequences of the Social Security lump-sum retroactive payment. In particular, an individual’s monthly retirement benefit gets recalculated. In particular and most importantly, the ongoing monthly retirement benefit will not include the earned DRCs.
In Francis’ case, the Social Security Administration representative was technically correct. If Francis had elected to claim his Social Security monthly benefit for the month of January 2022, he would have received (according to Francis’ most recent Social Security statement) a monthly retirement benefit of $2,500. If he elects instead to claim his Social Security monthly benefit for the month of July 2022, he will be eligible to receive a lump-sum retroactive payment consisting of 6 months-worth (maximum) of monthly retirement benefits going back to January 2022; that is, 6 times $2,500 per month or $15,000. But his monthly check for July 2022 and for the remaining 5 months of 2022 will be $2,500 per month and not $2,600 per month (4 percent DRC of $2,500 equals $100 added to $2,500 for a total of $2,600).
Hazards and Pitfalls of a Lump-Sum Social Security Retroactive Payment
There are some hazards and pitfalls associated with taking a lump-sum Social Security payment, including:
- Dying “later than earlier.” In Francis’ case, the lump sum retroactive payment is $15,000. On the other hand, if Francis elects to start his monthly benefit in July 2022, his DRC is 6 months times 2/3 of 1 percent per month or 4 percent. Four percent of $2,500 is $100. The $100 added to FRA monthly benefit of $2,500 results in a monthly benefit of $2,600. If one divides $15,000 by $100, the result is 150 months. This means that if Francis were to die 150 months (12 years and 6 months) past his FRA of 66 years and 2 months – that is, after he reaches age 78 years and 8 months in May 2034 – he made the wrong decision by taking the 6 month lump-sum payment of $15,000 (and therefore starting to receive a first-year monthly benefit of $2,500).
- The effect on a future Medicare Part B monthly premium as a result of taking the lump-sum payment. Francis is still working and covered by his employer’s group-sponsored health insurance plan. He is not required to enroll in Medicare Part B until he retires from federal service. He intends to retire on June 30,2022 and will enroll in Medicare Part B sometime in late summer or fall 2022.
During 2022, the standard Medicare Part B premium is $170.10 per month. But if a married individual’s 2020 modified adjusted gross income (MAGI) was above $182,000, the individual’s monthly premium will increase due to income-related monthly adjustment amounts (IRMAA). The individual could pay monthly premiums of $238.10 or $340.28 per month, or more.
In Francis’ case, his 2022 and 2023 Medicare Part B premium will be based on his 2021 MAGI (assuming he has filed his 2021 federal income tax return). His 2022 MAGI will impact his 2024 Medicare Part B monthly premium. Taking a lump-sum payment from Social Security during 2022 could increase Francis’ MAGI to the extent that Francis may have to pay more a monthly premium for Medicare Part B during 2024, a result of his ending up in a higher income tier and subject to IRMAA.
- Lump-sum Social Security retroactive payment lowers the spousal survivor (widow/widower) benefit. Perhaps the most consequential result of taking a lump-sum retroactive payment is that the individual’s spouse will receive a smaller survivor benefit if the individual predeceases the spouse.
As explained above, waiting 6 months to claim results in a 4 percent delayed retirement credit. Francis’ monthly benefit of $2,500 per month will increase 4 percent to $2,600 per month if he forgoes the retroactive monthly payment and starts to receive his Social Security monthly benefit in July 2022. If Francis dies 20 years later and. assuming average annual cost-of-living adjustments (COLAs) of 3 percent, his monthly benefit will increase to $4,896 per month. If Francis dies at that time, his spouse would be eligible to receive the widow benefit of $4,896. But if Francis chooses the lump-sum retroactive benefit, his monthly benefit will start at $2,500 per month. In 20 years, the $2,500 monthly benefit will increase to $4,515 per month assuming 20 years-worth of COLAs averaging 3 percent per year. If Francis dies at that time, his spouse would be eligible to receive the widow benefit of $4,515, which is $381 less per month compared to Francis’ not taking the lump-sum payment and the $2,600 starting Social Security monthly benefit. $381 per month ($4,572 per year) is a significant amount of money, especially when an individual is in his or her 80’s and 90’s. Every dollar extra from Social Security helps a widow or widower offset Medicare Part B premiums and meet other expenses, and to preserve savings.
While the Social Security retroactive lump-sum payout may sound financially attractive, an individual who is eligible to receive the payout is advised be fully aware of all of the consequences associated with the payout. In particular, how taking a lump sum payment will affect his or her current and future monthly Social Security retirement benefit and at their death, the widow/widower Social Security benefit for their surviving spouse.
Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While the employees of Serving Those Who Serve are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.