Conventional wisdom says that delaying Social Security results in higher lifetime benefits. While that’s true for many retirees, financial planners say there is one niche situation where filing before age 62 — and investing the entire benefit check instead of spending it — can produce a better financial outcome, though with a few important caveats.
Most Americans can begin collecting Social Security retirement benefits at age 62. But the “full retirement age” for people born in 1960 or later is 67. Each month before that age, Social Security takes about half a point of your retirement age benefit. That may not sound like much, but it adds up to a 30% discount if you start receiving payments at 62. The reduction is permanent.
Conversely, you can increase the amount of your monthly benefit if you wait even longer, thanks to the Social Security system’s delayed retirement credits, or DRCs. For each month you delay, from your full retirement age until age 70, you get two-thirds of a percent more. Again, that may not sound like much, but waiting until 70 can make you eligible for up to 124% of your benefit, which is about $500 a month for a retiree.
Of course, most people start receiving Social Security at 62 because they need the income and have no other option. A survey of working-age Americans conducted last year by investment management firm Schroders found that nearly half — 44% — plan to take benefits before age 67. Data from the Social Security Administration shows that about 8% of retirees wait until age 70 to start taking benefits.
Some retirees who can’t wait, may benefit by claiming benefits at age 62 and investing that money in an index fund.
Back-of-the-napkin calculations suggest this file-early-and-invest strategy could generate about $235,000 by the time you turn 70, assuming stock returns match the S&P 500’s historical average of about 10% per year.
If you took that money out over the next 10 years, your monthly payment would be $150 more than if you were to wait until 70 to start taking Social Security in the first place.
Bear markets, taxes and other risks abound
But that roughly $150 extra per month comes with a big asterisk attached: If the market doesn’t perform well and its historical average annual return is 10%, you might get a lot less money, especially if your first few years after taking Social Security at 62 coincide with a sharp downturn like the Great Recession, when the major indexes lost more than 50% of their value.
Retirees should balance growth and risk based on their income needs: More exposure to the stock market can generate more income in good years, but a recession may mean you have to cut back on your spending or draw on principal, permanently reducing the amount of income you can expect your nest egg to produce in the future.
For many retirees, Social Security is their only source of guaranteed income. Exposing that money to market volatility carries additional risk that may not suit retirees’ goals or provide them with financial peace of mind.
“[Social Security] it’s an asset class that you might consider undervalued or unrelated to the stock market,” says Peter Gallagher, managing director of Unified Retirement Planning Group in Briarcliff Manor, NY.
“You’re basically taking an investment and putting it into the same type of asset class,” he said.
There are also potential tax consequences to those investment earnings. Unlike a Roth IRA or 401(k), which allows for tax withdrawals in retirement, you’ll pay taxes on investment gains if you put your Social Security money into a brokerage account.
And even if you don’t use your Social Security money for everyday expenses, it counts as income that can trigger Medicare premiums for high earners, or it can make you ineligible for income-based health insurance subsidies — an important feature if you want to retire early and find a market plan until you qualify for Medicare.
If you are married and were the primary breadwinner during your working years, remember that filing early reduces how much Social Security your spouse will receive if they outlive you. Increasing the surviving spouse’s benefits is important because widows and widowers already face the inevitability of lower incomes when they go from two Social Security payments to one.
“What’s often overlooked is that the surviving spouse will have a reduced income, because they’ll stop receiving the amount of their spouse’s or their own benefits,” says Kevin Chancellor, Social Security strategist and CEO of Black Lab Financial Services in Melbourne, Fla.
Where a claim-early-and-investment may make sense
That said, there are situations where filing for Social Security early and investing those funds makes sense, but the goal is not to use the money to pay for your retirement. “Real earnings don’t drag you down at all” over your lifetime, Chancellor said. Instead, an early claim-and-invest strategy can be an efficient, tax-efficient way to leave a financial legacy to your heirs.
A taxable investment account with several years of Social Security benefits can grow to a large balance if you don’t touch the money before you die. It is also advantageous compared to other inherited assets.
If you leave an heir (not including your spouse) a retirement account funded with pre-tax dollars, they only have 10 years to draw down the balance, and that amount is added to their annual taxable income.
If you want to leave an IRA to an older child and expect to have a normal life expectancy, there is a good chance that the account will pass into their hands when they reach the peak of their career. A 10-year drawdown window that significantly exceeds the age of inheritance can mean large tax bills.
On the other hand, if you leave them an investment account funded with your Social Security benefits, they’ll actually get a tax break if they inherit it. A provision called the step-up in basis rule resets the account value to its balance on the date of your death.
Conclusion: Your heirs are not liable to pay taxes on the capital gains that occurred during your lifetime. They will only have to pay taxes on the profits earned after your death; and, those gains are taxed at capital gains rates, which are lower than ordinary income tax rates.
While this situation may make financial sense for some families, however, the loss of higher monthly payments is not a decision that can be made lightly. The most important thing for retirees to remember is to make sure their financial needs are met first, said Gallagher.
“As long as you know you have enough – ‘put your mask on first’ in a flight situation,” he says. At the end of the day it comes down to whether they need the income or not.”
