Many people decide to claim their Social Security benefit when they retire. You may be one of them. It could be that you need the money, or maybe you want to invest it in the hope that it grows. While these can be good options depending on your needs and preferences, they aren’t the best choices for everyone.
This is especially true if you retire before your full retirement age. Even if you intend to invest your monthly payment, there are some risks and drawbacks you need to be aware of.
Taking larger initial savings withdrawals and buying an annuity are two ways to bridge the gap while you wait.
Claiming Early Reduces Your Benefit
First, understand that claiming Social Security before you reach full retirement age permanently reduces your monthly benefit. The amount could be significant depending on how early you file.
For each month before your full retirement age, your benefit is reduced by:
- 5/9 of 1% for each month up to 36 months
- 5/12 of 1% for each month past the 36th month
This can add up to a 30% reduction if you file at the earliest possible time. So if your benefit would have been $2,000, you’d receive $1,400 instead.
Investing Involves Risk
One benefit of Social Security is that it functions like a pension. You receive a regular payment that is guaranteed for life. Filing early to invest those dollars not only reduces this secure source of income but also adds volatility through the investments. In other words, you’re swapping a secure asset for a risky one.
This doesn’t necessarily mean that investing is bad. Depending on the performance of the investments you choose, you may expect to see those dollars grow more than your benefit over time- but you need to be aware of that risk difference when deciding.
Social Security Provides Inflation Protection
If you file early, invest your benefit and then experience investment losses, inflation could compound them. During periods of high inflation, you’ll have to withdraw even more to make up for the increased cost of living. Taking larger withdrawals from a portfolio that is down can erode your savings quickly.
However, your Social Security benefit increases with inflation each year. Because of this, your purchasing power remains constant regardless of what happens with the market or how high inflation gets. Maximizing your Social Security benefit maximizes this inflation protection.
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Social Security Is More Tax-Efficient
An advantage of waiting to claim your Social Security benefits is that Social Security is taxed more favorably than other types of income. Unlike other income sources, it is never fully taxed. The portion of your Social Security benefit that counts toward your taxable income depends on your combined income.
At lower income levels, your Social Security benefits may be completely tax-free. In the worst case, only 85% of your benefit will be taxable. If you file early and invest, you’ll be taxed on any dividends, capital gains and interest you earn. While some of these, like long-term capital gains, may be taxed at lower rates, it’s important to weigh these tax differences in your decision.
Taking Larger Savings Withdrawals
A simple way to make up for delaying your Social Security benefit is to withdraw more from your savings until you reach full retirement age or later. Then, when you begin drawing your unreduced benefit, you can reduce the savings withdrawals you take going forward.
While this move is a good choice for many people, it increases your exposure to sequence risk, or the chance that markets perform poorly during the early years of your retirement. This can put significant strain on your savings and increase the chance that you run out of money too soon.
Make sure to account for protecting yourself from sequence risk if you choose this route.
How Can Annuities Help?
Filing early to invest your benefit is mostly a matter of personal choice. When weighing your options, consider your decision within the context of your complete plan and in light of the issues mentioned above.
But if you are thinking about filing early because you need the money, an annuity may be a better choice.
Bridging the Gap
Instead of filing early and permanently reducing your Social Security, you can buy an annuity to bridge the gap so you can delay, maximizing the benefit you’ll eventually receive.
For example, suppose you are 62 and your full retirement age is 67. You can buy an immediate annuity with a five-year period certain. It will provide a fixed payment until you reach full retirement age and claim your unreduced Social Security benefit.
Replacing Uncertainty With Security
Many annuities offer fixed interest rates and guaranteed payments, providing a similar level of security as Social Security payments. Rather than relying on larger withdrawals from your savings before your Social Security payments start, you can replicate that protection with annuity payments.
This provides particularly good protection from sequence risk because it shields you from the effects of market volatility. You won’t be forced to withdraw from a portfolio that has suffered investment losses while you receive regular payouts from a fixed annuity.
Providing Longevity Protection
Annuities can provide protection in the long run as well. One key issue to address in a distribution plan is how long you need the money to last. Since no one knows how long they will live, that’s another area where uncertainty plays a large part.
Annuities, like Social Security, mitigate the risk of living longer than expected because the payments from a life annuity are guaranteed for as long as you live. This provides protection from longevity risk and can enhance your quality of life. If you know you have annuity payments to rely on, you will feel more comfortable spending from your other savings.
Editor Norah Layne contributed to this article.
