Social Security: 3 Penalties to Avoid

Social Security is the largest retirement benefit program in the U.S., and the most common source of inflation-protected, stable income for elderly Americans. It represents 30%-50% of retirement income for most people.¹ So, if you’re counting on Social Security as a significant retirement income source, it’s critical you’re aware of potential reductions. Here are three important ones to avoid.

Windfall Elimination Provision (WEP)

Social Security is designed to replace about 40% of the average retiree’s income, but the benefit’s formula clearly favors lower-income workers. Specifically, Social Security calculates your average indexed monthly earnings, or AIME, from the 35 highest-earning years of your career, and applies it to this formula (for 2023):

• 90% of the first $1,115 of AIME
• 32% of the amount over $1,115 through $6,721
• 15% of the amount over $6,721

For example, if your Social Security benefit is based on $1,000 of average monthly earnings, you would get $900, or 90% of your income. On the other hand, if your average monthly earnings were $5,000, this formula would result in a monthly benefit of $2,247, which works out to 45% of pre-retirement income. In short, people with lower average earnings throughout their career can replace a greater percentage of their income through Social Security benefits. To be perfectly clear, this is exactly what Social Security is intended to do.

However, there are some people whose income record classifies them as lower earners, although, in reality, that isn’t the case.

Let’s say that you worked for 30 years in a high-paying job and your employer did not withhold Social Security taxes, but had its own pension plan. This is more common than you might think—about 11% of U.S. workers ages 21 to 64 are in non-covered employment.² Examples include some government workers, employees who work for a foreign company, and railroad employees. Then, after retiring from that job, you work in covered employment and pay Social Security tax for 10 years.

In this case, your average monthly earnings for Social Security will be calculated using the 10 years of data when you were a covered employee and assign zeros to the other 25 years. As a result, your average will be quite low. To prevent you from receiving a full pension and a Social Security benefit that’s intended to help a low-income retiree, the Windfall Elimination Provision, or WEP, was passed by Congress. WEP reduces the 90% multiplier in the formula to as low as 40% based on several criteria.³

The WEP looks at the number of years in which you had “substantial” earnings— which is defined as a minimum of $29,700 for 2023. So, if you had more than 10, but fewer than 30 years of substantial earnings under Social Security-covered employment and receive a pension from an employer who didn't withhold Social Security taxes, the WEP will apply to your earnings and the 90% multiplier in the formula will be reduced.⁴

As a basic example, someone with an AIME of $1,000 per month who had substantial earnings in 30 years would be entitled to $900 per month at full retirement age. On the other hand, someone with a $1,000 average with only 25 years of substantial earnings would only get $650.

The WEP affects about two million Social Security beneficiaries, of which 1.9 million are retired workers. This is about 4% of all retired workers collecting Social Security.⁵

Early retirement penalty

Over time, the average age when workers claim their Social Security retirement benefit has gradually increased. As of 2018 (the latest data shared by the Social Security Administration (SSA)), the average claiming age is 64.7 years old for men and 64.6 years old for women. In 1998, the average claiming ages were 63.4 and 63.5, respectively.⁶

Based on this data, the average American starts collecting Social Security benefits before reaching full retirement age, or FRA, which is 67 years old for people born in 1960 or later. About 30% of people sign up for Social Security at age 62, the earliest age possible, according to the Congressional Research Service.⁷ Another popular claiming age is 65—the age of Medicare eligibility.⁸ So, it’s important to know how receiving benefits before FRA can affect your monthly income.

Social Security benefits are based on a formula applied to a worker’s average monthly earnings throughout their career (more on that in the next section). But this formula assumes you don’t start collecting benefits until reaching FRA.

If you choose to start collecting Social Security before reaching FRA, your benefit will be permanently reduced according to two rules.

• For up to 36 months prior to FRA, the initial monthly benefit will be reduced by 6.67% per year.
• Beyond 36 months early, the benefit will be further reduced by 5% per year.

Here’s what this means. If your full retirement age is 67 and you claim at 62, your retirement benefit will be reduced by 6.67% for three years and 5% for the next two, for a total reduction of 30%. In other words, if you would get $2,000 per month at age 67, you would only get $1,400 at 62.

Conversely, if you wait to start Social Security beyond your full retirement age, your benefit will be permanently increased by 8% per year. And you can wait until as late as age 70. In other words, if your full retirement age is 67, you can permanently increase your benefit by 24% if you wait as long as possible.

It's a common misconception that the typical Social Security beneficiary will receive the same (inflation-adjusted) amount of money throughout their retired life, regardless of the age at which they claim. However, due to today’s longer life expectancies, the average person can get significantly more money overall by waiting as long as it’s practical to do so.

However, there are some perfectly valid reasons for claiming Social Security early. For example, if your health prevents you from working until FRA, it can be a smart financial move to start collecting early.

Income penalty (the earnings test)

In addition, you can be penalized (at least temporarily) if you work after you claim Social Security. This is extremely important to know if you claim Social Security before reaching your full retirement age.

However, if you have already reached full retirement age, you can work and collect Social Security at the same time with no effect on your benefit. On the other hand, if you haven’t yet reached full retirement age, you are subject to the retirement earnings test (RET). And there are two rules:

• If you reach FRA after 2023, you can earn up to $21,240 this year with no effect on your Social Security benefits. If you earn more, $1 is withheld for every $2 you earn.
• If you reach FRA during 2023, the maximum is $56,520, and $1 is withheld for every $3 above this threshold. However, this only affects months before your birth month. For example, if you were born in May, only January through April would count.

If you are affected by the earnings test, it’s important to understand how it works. Specifically, the SSA uses your estimated earnings to determine how much of your benefit should be withheld, and then it withholds all of your benefits, starting in January, until it has reached the appropriate amount. The SSA does not withhold partial monthly benefits due to the earnings test.

As an example, let’s say that you are 64 years old and estimated that you’ll earn $32,000 in 2023. According to the earnings test limit, you should have $5,380 withheld from your Social Security checks. If your monthly Social Security benefit is $2,000, you can expect to have your first three (January, February, and March) Social Security payments withheld in their entirety. The excess withholding will be returned to you after the end of the year once your actual earnings are known.

The retirement earnings test only considers earned income. Retirement income—such as pensions or distributions from a 401(k)—doesn’t count.

If you are affected by the earnings test, and benefits are withheld from you, they aren’t exactly lost. Your monthly benefit will be adjusted upward once you reach FRA to account for any amounts withheld. In fact, the SSA claims that the typical beneficiary affected by the earnings test will recoup most or all of the withheld benefits.⁹

Weigh these penalties alongside other opportunities

It may not be possible or practical for everybody to avoid these penalties completely. If you have a great job that happens not to be covered by Social Security, there’s no need to re-think your career choice just because of the WEP. Likewise, there can be some good reasons to start Social Security early. And if you claim Social Security when you’re 62 and a couple of years later get a lucrative job offer that triggers the earnings test, it can certainly be a good problem to have.

So, as your retirement strategies evolve over the years, keep in mind these three Social Security penalties and how they might affect your retirement income. Our Wealth Advisors talk frequently with clients about the pros and cons of different claiming options and ways to shift your strategy depending on the capital market conditions.