Your Social Security Check Might Be Smaller Than You Expect

Social Security provides a significant source of income during retirement. However, a recent study from Nationwide's Retirement Institute shows that many American workers are too optimistic about the amount they'll receive in Social Security when they retire. Are you overestimating how big your check will be, too?

It's not a simple calculation

You may have heard that Social Security will replace a percentage of your income in retirement, but unless you understand how the program calculates your benefit, you might think you'll get more than you really will when you retire.

First, it's important to remember that Social Security is a pay-as-you-go program. That means money that's taken out of your weekly paycheck is used to pay Social Security to current retirees. It's not set aside in an account specifically for you, like an IRA.

Second, you may have heard that Social Security replaces 40% of the average American's pre-retirement income. That's not necessarily true. Yes, it's designed to replace about that much, but only to the average recipient.

You see, Social Security's calculation is complex. It adjusts a worker's highest 35 years of income into current dollars to determine his or her average monthly pay. Then it calculates the primary insurance amount -- or the retirement benefit at full retirement age, the age at which people can receive 100% of their benefit -- by applying multipliers that only give credit for a specific proportion of average monthly income at different thresholds.

For example, people retiring in 2018 only get credit for 90% of their primary insurance amount up to $895 per month, 32% of the amount between $895 to $5,397, and 15% of any amount over $5,397.

That means Social Security will replace more than 40% of income for people with lower earnings over their career and less than 40% for people with higher earnings over their career.

Plan for the worst, not the best

You might be planning to claim Social Security as late as possible so that you benefit from Social Security's delayed retirement credits. These credits are awarded to people for every month they delay taking benefits beyond full retirement age, and they can really add up. In fact, they can increase your Social Security check by about 8% annually, up to age 70.

However, planning to retire as late as 70 to get the biggest check possible might not be wise. Many people expect to delay retirement until then, but instead they end up claiming earlier than that because of health problems or job loss.

If you end up in a similar situation and you didn't prepare for it, your retirement plans could fall short. You can claim Social Security benefits as early as age 62, but that's the age at which you'll get the smallest Social Security check.

You see, Social Security may reward you for claiming after full retirement age, but it punishes you if you claim early. Social Security income will be reduced by five-ninths of 1% per month for the first 36 months and five-twelfths of 1% for each additional month claimed early. That means someone with a full retirement age of 67 who claims at age 62 will only receive 70% of the full retirement age benefit.

Social Security's fine print

You might be thinking of claiming early and continuing to work, but if you don't consider Social Security's earnings test, you might end up disappointed.

After you reach your full retirement age, you can earn as much as you want without having any of your Social Security income held back. However, if you claim early and your earnings exceed a set limit, your Social Security income will be reduced.

For instance, if your full retirement age is after 2018, then you can earn up to $17,040 this year without triggering the reduction to your benefit. If you earn more than that amount, then Social Security will hold back $1 for every $2 you earn above the limit.

Or if your full retirement age is this year, then you can earn up to $45,360 in the months before turning full retirement age without triggering the reduction. If you exceed that amount, though, you'll have $1 withheld for every $3 earned above it.

Plan for the tax man (and call Congress!)

Once upon a time, Social Security wasn't subject to federal income taxes, but it is now, depending on your income.

The good news is that the IRS won't tax any more than 85% of your Social Security income. The bad news is that it will tax at least some of your Social Security income if your combined earnings are higher than $25,000 if filing as an individual, or $32,000 if you're married filing jointly. The IRS determines your combined income by adding your adjusted gross income, your nontaxable interest income, and one-half of your Social Security benefits.

Your Social Security income may also fail to match your expectations if Congress doesn't shore up the program's finances. That's because Social Security is paying out more to retiring baby boomers than it's collecting in payroll taxes from current workers. To close the gap, Social Security is tapping its trust fund, but Social Security's trustees expect that fund to run out of money in 2034. If something doesn't get done to increase Social Security's revenue by then, the trustees estimate that everyone's benefit will have to be cut by about 25% to balance Social Security's budget.

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