Part 1 of this post introduced the Social Security “do-over” or, as I like to refer to it, “pay-to-play” Social Security strategy. Basically, this strategy provides individuals who elected to begin receiving their Social Security retirement benefits before age 70 with the ability to increase their future monthly benefit. In order to receive this ongoing increase, which, in some cases may be substantial, you’re required to pay back 100% of the Social Security benefits that you’ve received from the date you began collecting your benefits. As stated in Part 1, you’re entitled to claim a tax credit or tax deduction for the amount of tax liability attributable to your benefits, whichever results in the most tax savings.
In order to determine if the use of this strategy makes sense, some serious number crunching is necessary. Even though I’m not old enough to collect Social Security yet, I used benefit information from my Social Security Statement to prepare a hypothetical example in Exhibit 1. Per my Statement, here are the projected monthly benefits that I’m entitled to receive at various ages:
- Age 62 = $1,805
- Age 65 = $2,475
- Age 70 = $3,282
Let’s fast forward and assume that I turned 62 in 2002 and, at that time, made an election to begin receiving my monthly benefit of $1,805, or $21,660 per year. Applying Social Security Administration’s annual cost-of-living adjustments, or COLA’s shown in column 3 of Exhibit 1, my annual benefit would have increased each year by 1.4% (in 2003) to as much as 5.8% (in 2009), with my 2009 annual benefit being $26,804. This represents an increase of $5,144, or 23.7% of the benefit of $21,660 that I was receiving seven years prior in 2002.
Here we are in 2010. Since there was no COLA in 2009, my 2010 annual Social Security benefit will be the same as what it was in 2009, or $26,804 if I do nothing. Using the “do-over” or “pay-to-play” Social Security strategy, and assuming that my spouse isn’t receiving a spousal benefit (See Do Your Homework Before Flipping the Social Security Switch – Part 4 of 5), per Exhibit 1, in exchange for writing a check to Social Security Administration for the amount of my cumulative benefits of $189,956, I will receive a monthly benefit of $3,282 vs. $2,234 ($26,804 divided by 12). On an annual basis, I will receive $39,384, or $12,580, or 46.9% more, than the benefit of $26,804 that I would receive if I don’t employ this strategy.
While there is no COLA for 2010 or 2011, Exhibit 1 assumes annual COLA’s of 2% each year beginning in 2012. Once these COLA’s kick in, the annual “do-over” increased benefits, i.e., the difference between the amount of the “do-over” benefit and my current projected benefit, is projected to escalate each year. Per Exhibit 1, the annual “do-over” increased benefit is projected to increase from $12,580 in 2010 to $13,617 in 2015 to $15,034 in 2020, etc.
Exhibit 1 assumes that I will reinvest my increased annual benefit that I receive beginning at age 70. It further assumes that my after-tax reinvestment rate will be the same as the rate that I would have earned had I chosen to invest the Social Security repayment amount of $189,956. Ignoring potential income tax savings that I would receive from the tax credit or deduction attributable to the income tax that I paid from 2002 through 2009 on my total Social Security benefits of $189,956, per Exhibit 1, it would take until sometime when I’m 83, or almost 13 years, for my cumulative “do-over” increased benefits to exceed my Social Security payback amount.
Although up to 85% of one’s Social Security benefits can be taxable at federal tax rates as high as 35% which may increase to 39.6% beginning in 2011, let’s assume that 50% of my benefits between 2002 and 2009 have been taxable at a rate of 25%. The income tax attributable to my cumulative benefits of $189,956 is $23,745 (50% x $189,956 x 25%). Since I would be receiving income tax savings of this amount when I write my check to Social Security Administration, my out-of-pocket cost would be $166,211 ($189,956 – $23,745). Per Exhibit 1, “break-even” would occur when I turn 82 since my cumulative “do-over” increased benefits of $165,658 at age 81 would be slightly less than my after-tax “do-over” payback of $166,211.
Per Exhibit 1, the longer I live, whether it’s until 82 if I’ve previously paid income taxes on my Social Security benefits or sometime into my 83rd year if I haven’t, the “pay-to-play” Social Security strategy becomes more and more attractive. Although I’ve done a fair amount of number crunching, there’s one more step remaining in my analysis to determine whether the strategy makes sense for me. Stay tuned for Part 3 next week.