3 Social Security Misunderstandings That Could Cost You

By Maurie Backman Markets Fool.com

Social Security helps millions of seniors stay afloat financially once they retire. But without a clear understanding of how the program works, you could be in for some unpleasant surprises once you come to rely on those benefits. Here are three misconceptions you'll need to get straight.

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1. Claiming Social Security early will temporarily reduce your benefits

Your Social Security benefits are calculated based on how much you earned during your working years. Once you reach your full retirement age, you'll be able to collect your benefits in their entirety. Your full retirement age is determined by your year of birth, as follows:

Year of Birth

Full Retirement Age

1943-1954

66

1955

66 and 2 months

1956

66 and 4 months

1957

66 and 6 months

1958

66 and 8 months

1959

66 and 10 months

1960

67

DATA SOURCE: SOCIAL SECURITY ADMINISTRATION.

Now you don't have to wait until your full retirement age to file for benefits. In fact, you're allowed to start taking Social Security once you turn 62. Doing so, however, will result in a reduction of benefits. Specifically, you'll lose 6.67% of your full benefit amount for up to three years and then 5% a year thereafter. This means that if your full retirement age is 67 and you file for benefits at 62, you'll reduce your payments by 30%.

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IMAGE SOURCE: GETTY IMAGES.

But contrary to what you may have been led to believe, if you file early, your payments won't revert to their full, non-reduced amount once you reach your full retirement age. Rather, any reduction you take in benefits will remain in effect for the rest of your life. That's why it's important to weigh the drawbacks of claiming benefits before reaching full retirement age. Though you will get access to that money sooner, you'll get a lower monthly benefit forever.

2. You must file for benefits once you reach your full retirement age

Waiting to reach full retirement age will ensure that you don't face a reduction in benefits, but there's actually no requirement to file for benefits on time. In fact, if you hold off on claiming Social Security, you'll get an 8% boost in benefits for every year you delay. This incentive does run out at age 70, but if your full retirement age is 67 and you hold off for three years, you'll increase your benefits by 24%.

Keep in mind that while delaying Social Security will make your actual payments bigger, you won't necessarily collect more in lifetime benefits than you would by filing on time. Taking benefits at 70 instead of 67, for example, means losing out on 36 additional payments. To figure out if it pays to delay Social Security, you'll need to calculate your breakeven point, which is the age at which you'd come out with the same lifetime benefit whether you file late or on time.

Here's an example. Let's say your full retirement age is 67, and your full benefit amount is $1,600. Delaying until age 70 will boost your monthly payments to $1,984, but you'll get fewer payments. In this case, your breakeven age would be 82.5, because at that point, you'll have collected the same lifetime benefit amount ($297,600) in either scenario. If you think you'll live past 82.5, then holding off on Social Security makes sense. But if you have reason to believe you won't make it to 82.5, then you're better off filing earlier.

3. You can live off Social Security alone

The National Academy of Social Insurance reports that Social Security is the only source of income for roughly 25% of Americans 65 and older. And that's a problem, because Social Security was never designed to sustain retirees on its own. In fact, the Social Security Administration makes a point of stating that its monthly benefits will replace about 40% of the average worker's pre-retirement income. Most people, however, need a good 70% to 80% of their former income to pay their bills in retirement. And depending on your healthcare costs and lifestyle, you could end up needing even more.

In fact, according to the Employee Benefit Research Institute, almost half of senior households spend more money, not less, during their first two years of retirement than they did at the end of their working years. For 33% of households, this trend continues for at least six years in retirement. If you don't have a source of income outside of Social Security, you risk coming up short during your golden years.

Thankfully, there are plenty of options for generating income in addition to Social Security. Maxing out retirement plan contributions could help you accumulate enough savings to cover your senior living costs, especially if you start early enough and invest wisely. Current workers under 50 can contribute $18,000 a year to a 401(k) and $5,500 to an IRA, and these limits increase to $24,000 and $6,500, respectively, for workers 50 and older. Fund either type of retirement account with $300 a month over 30 years, and you'll have an ending balance of $340,000, assuming your investments generate an average annual 7% return.

If you're already well into your 60s and don't have time to catch up on savings, you could try working part-time in retirement or starting your own business to generate cash. No matter what you do, don't make the mistake of thinking your benefits will be enough to cover the bills. Chances are, they won't even come close.

The more you know about Social Security, the better equipped you'll be to maximize your benefits once it's time to collect them. Whether you're a few years or a few decades away from retirement, it pays to learn more about how Social Security works so you can make the most of this important program.

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