Pay-to-Play Social Security – Part 3 of 3

Pay-to-Play Social Security – Part 3 of 3

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If you haven’t done so already, I would highly recommend that you read parts 1 and 2 of this series before diving into Part 3. Part 1 introduced a strategy called the “do-over,” or, as I like to refer to it, “pay-to-play” Social Security. In a nutshell, the use of this strategy enables Social Security recipients who are less than 70 to increase the amount of their retirement benefit in exchange for repayment of all benefits received to date. Part 2 used a hypothetical example of an individual who had been collecting Social Security since age 62, paid back 100% of his benefits totaling approximately $190,000, and was projected to recoup his payback in 12 – 13 years via projected benefits of approximately 47% greater than what he was previously receiving.

The success of this technique is dependent upon surviving the “break-even” period. Suppose the individual, let’s call him Sam, in our hypothetical example is single, is in good health, and decides to implement this strategy, writing a check to Social Security Administration for $190,000. After receiving one increased monthly payment of $3,282, or $1,048 greater than his former monthly payment of $2,234, Sam suffers a major heart attack and dies. Guess what? Assuming that Sam invested his additional monthly benefit of $1,048, Sam’s beneficiaries will receive $189,000 (190,000 – $1,000) less than what they would have received had Sam done nothing. Furthermore, once again assuming that Sam invests his additional monthly benefit of $1,048 each and every month, Sam needs to survive for 12 – 13 years in order for Sam and his beneficiaries to benefit from Sam’s implementation of the “pay-to-play” strategy.

Knowing that premature death is a risk, some individuals go ahead and implement the strategy thinking that it’s a bargain compared with what it would cost to buy an immediate life income annuity with annual cost-of-living increases from an insurance company. For those of you who aren’t familiar with the concept of an “immediate life income annuity,” allow me to explain. In exchange for a lump sum investment, or premium, an insurance company will make a monthly payment to you for the remainder of your life, with all payments ending upon death. An optional cost-of-living increase provides that the payments will increase each year by a specified percentage, typically 1% to 6%. Since the benefit will increase each year, the premium will be greater than what would otherwise be required without this option.

Let’s see how much of a bargain the use of the “pay-to-play” strategy is compared to purchasing a commercial annuity using our example. In order to duplicate the proposed increased monthly Social Security benefit of $1,048 plus an assumed cost-of-living adjustment of 2% beginning in 2012 per Exhibit 1 of Part 2 of this blog post, I ran annuity illustrations with three highly-rated life insurance companies, solving for the required premium, using the following eight parameters:

  1. Sex – Male
  2. Age – 70
  3. State of residence – California
  4. Type of annuity – single-premium life income annuity
  5. Payment amount – $1,048
  6. Payment frequency – monthly
  7. Annual increase – 2%
  8. Contract type – non-qualified

The state of residence is important because some states, including California where I live, assess a premium tax on annuity investments which, in turn, increases the amount of premium that would otherwise be payable in those states which don’t assess the tax. Using the foregoing assumptions, the amount of premium required ranged between approximately $189,000 and $192,000 for the three companies. This is identical to the payback amount of approximately $190,000 per Exhibit 1 of Part 2. As stated in Part 2, the analysis needs to be extended to include income tax savings attributable to the payback, which, in our example was approximately $24,000, reducing the after-tax cost of the payback to $166,000 ($190,000 – $24,000).

In the hypothetical example, at first blush, the payback of approximately $190,000 isn’t a bargain when compared to the purchase of a commercial annuity providing comparable increased benefits, i.e, $1,048 a month plus 2% annual increases. It isn’t until the income tax savings of approximately $24,000 is considered that it becomes apparent that the after-tax cost of $166,000 is less than the annuity premium, making the “pay-to-play ” strategy vs. purchase of a commercial annuity a potentially better way to go in this example.

“Potentially” is the operative word because, in addition to the possibility of premature death, three, or four additional factors, depending upon marital status, need to be analyzed and considered when evaluating this strategy:

  1. Whereas the annuity annual increase of 2% is locked in and will be paid each year by the insurance company, the annual Social Security benefit increase of 2% in Exhibit 2 of Part 2 is an assumed increase. Actual increases may be equal to, greater, or less than 2%, and can even be 0% as they have been the last two years.
  2. Under current law, up to 85% of Social Security benefits are taxable at federal income tax rates as high as 35% which are scheduled to increase to 39% on January 1st. Depending upon one’s tax situation, the after-tax increase of $1,048 a month may be only two-thirds of this amount, or approximately $700.
  3. Non-qualified annuity contracts are subject to an exclusion ratio. Basically this means that the portion of each payment that represents a return of principal is nontaxable. In the case of the three annuity illustrations, approximately 80%, or approximately $800, of each payment is nontaxable. The remaining 20%, or approximately $200 is taxable at one’s applicable marginal tax rate
  4. For married individuals where one spouse is receiving a “spousal benefit,” additional analysis is required.

As you can see, I wasn’t kidding when I stated in the beginning of Part 2 that some serious number crunching is necessary in order to determine if the use of the “do-over,” or “pay-to-play” strategy makes sense in your situation. Besides the fact that this strategy isn’t well publicized, it’s no wonder that very few individuals actually implement it. The future use of this strategy may become a moot point since, as stated in Part 1, it may be discontinued by Social Security Administration in the near future.

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