Just How Big a Social Security Hit Do Early Retirees Take?

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Getting the most you can from Social Security is an important part of ensuring your financial security after you retire. One goal that many people have is to retire early, and that can create financial challenges that you need to address before you pull the plug on your career once and for all.

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Early retirement affects Social Security benefits in a couple of ways. By working through the numbers and applying the program's rules to your particular situation, you can plan accordingly and make sure that you've made other arrangements to make up for any reduction in the monthly payments you were expecting from Social Security.

1. Smaller payments for life

The clearest hit that early retirees from Social Security suffer is the mandated reduction in the size of the monthly benefits they receive. If you retire up to three years before your full retirement age -- which is currently in the range of 66 to 67 for those considering early retirement now -- then you'll give up $67 in monthly benefits for every $1,000 you'd be entitled to receive at full retirement age. For years beyond three, the reduction is $50 per year. So if you retire three years early, you'd see a $1,000 monthly payment drop to $800. Retire four years early, and you'd get $750 per month instead.

It's true that in exchange for accepting those smaller payments, you receive more of them, and that can roughly even out over the long run for many retirees who live about as long as their actuarial life expectancies would suggest. Yet by taking those payments earlier, you'll get less later, and that forces prudent retirees to look for ways to replace that lost income later in their lives. Products like deferred income annuities can bridge the gap by providing payments that kick in at a specified age, like 80 or 85. But to buy those products, you need to plan to have the cash upfront to pay for them, and that can put a damper in your early retirement dreams if you're not prepared.

2. A shorter work history

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The other reason many early retirees get less than their optimal Social Security payment is that retiring early can shorten your work history below the threshold that the Social Security Administration uses to determine your benefits. Under current law, the SSA takes the average of your 35 highest-earning years, calculated after making allowances for inflation between the earliest years of your career and now. It then runs that average earnings figure through a formula to determine your benefit. In general, the higher your average earnings are, the greater the benefit you'll receive.

If you retire before working 35 years, then the SSA will just put zeros into your work record for purposes of calculating the average. So in very rough terms, each year that you retire early and miss out on a year of earnings history can reduce your average earnings by about 3%. For those who have peak earnings at the end of their career, the impact on average earnings can be even larger.

Fortunately, the actual reduction in monthly Social Security benefits isn't as large as what the average earnings figures would suggest. The formula that the SSA uses is set up progressively, with low-income earners getting as much as 90% of their pre-retirement income from Social Security while figures of 32% and even 15% apply to additional earnings from higher-income workers.

For instance, workers who averaged the equivalent of $42,000 per year in earnings in today's dollars throughout their careers and retired five years early would see their full retirement age benefits drop from $1,639 to $1,479 per month. That's just under a 10% reduction, which is less severe than the roughly 15% decline in average earnings would initially suggest. Nevertheless, it's still less money coming in, and early retirees have to take that amount into consideration in making decisions about when to end their careers.

Be smart about early retirement

Social Security is just one area where early retirees have to think about their finances. Finding alternative healthcare coverage is also important, especially for those who got group insurance through their workplaces. Being able to tap into IRAs and 401(k)s at ages from 55 to 59 1/2 can help, but you have to plan for the tax consequences of those move as well as not wanting to deplete your savings too quickly early on in your retirement.

Despite the financial challenges, early retirement is a worthy goal. Knowing the potential pitfalls will help you plan to avoid them and find a path to the retirement of your dreams.

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