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Understanding Social Security: When should you file for Social Security? Don’t be fooled by the ‘break-even’ analysis.

When considering the age you should file for Social Security benefits, often a break-even analysis is performed to compare the result between one filing age versus another.

The problem is that break-even analyses are good for comparing investments, and Social Security is not an investment, it is insurance, insuring you against living longer than expected. Insurance is not an investment, so a break-even analysis doesn’t apply adequately to the features of the coverage.

Check out the Social Security Administration’s benefits calculator 

Clients of mine, Marc and Sherrie, were recently in my office talking about this subject. Marc was getting ready to retire (at the age of 63), while Sherrie (age 58) is continuing to work for several more years. Marc figured that he’d start receiving Social Security as soon as he retires, in order to help cover their living expenses, since Sherrie’s job only covers about half of what they need.

Read: My husband claimed Social Security and I haven’t yet. How will that impact my benefit?

I suggested that since Sherrie is a few years younger than Marc, and since Marc’s Social Security benefit is roughly double Sherrie’s amount, he should consider delaying receipt of his benefits until at least his Full Retirement Age, perhaps even to age 70. In the meantime he could use the money in his IRA to make up the shortfall.

Marc seemed to be ready for this suggestion. “I did a break-even analysis on the benefits between starting now and starting at age 70, and I’d have to live to at least age 80 in order for delaying to pay off! I’d rather have the money now, and save my IRA for later. That’s all the money we have.”

Read: How does retiring early impact Social Security benefits?

The problem is that Marc is looking at Social Security as an investment (thus the break-even analysis) rather than as insurance — specifically insurance against living longer than you anticipate. This is also known as longevity insurance.

Read: I took Social Security at 62 and now regret it. Is there a way to increase my Social Security benefit?

Social Security is intended to pay you a specific amount, incremented by COLA adjustments regularly, over the remainder of your life. In addition, in a case such as Marc and Sherrie’s, assuming that Marc dies before Sherrie, his benefit will effectively continue on until the end of Sherrie’s life as well.

For a comparison that may help — you don’t do a break-even analysis on your home’s fire insurance, do you? No, of course not. You don’t say “Heck, it’s just such a small chance that my house will burn down, and no one’s house around here has burned down, so I’m just not going to get fire insurance.” You get insurance on your home to cover the unexpected, unanticipated, risks, such as fire, that you hope won’t happen. If the risk does happen, the insurance pays for the damage, replacement, or whatever cost the risk brought onto you.

By the same token, you have Social Security retirement benefits (properly referred to as Old Age and Survivors Insurance, or OASI) to guard against living longer than you’d expected. Your coverage in this case isn’t designed to provide you with the most money over your lifetime, but rather to guard against living longer than you expected. To take this to an extreme, let’s say you lived to be 120 years old. If, like most folks, you had planned for a “normal” lifespan such as to age 80 or so, then likely you would begin to run out of money some time around that age or shortly thereafter. 

Here’s where Social Security saves the day. No matter how long you live, Social Security retirement benefits continue paying, up to your death. And, as mentioned before, if your spouse’s benefit is anything less than your own benefit, your Social Security benefit will continue paying for the remainder of your spouse’s lifetime as well (assuming you die first).

So in Marc’s case, deciding to start his benefit early might allow him to delay using his IRA money for some time (until RMDs start anyhow), but in the meantime he’s shortchanging his coverage against living longer than anticipated. Adding Sherrie’s younger age to the picture just makes the situation even less desirable. Delaying his benefit out to age 70 versus age 63 will increase his benefit by a factor of almost two-thirds.

Marc was still not convinced that this made sense for his situation. After all, this means he’d need to withdraw a significant amount of his IRA funds in order to pay for living expenses for the next few years, and as he mentioned, his IRA is really all the money that he and Sherrie have in savings.

Sherrie on the other hand, caught on to the importance of increasing this benefit, given her younger age, the lower benefit amount would significantly cramp her living situation if Marc died before her.

Adding to the argument in favor of delaying, when you compare Social Security benefits with an IRA, you need to consider the characteristics of these two “assets.” An IRA is a specific amount of money, although that amount of money may grow over time, when you begin taking withdrawals from it (assuming the withdrawals are significant) eventually you will withdraw the entire balance and have nothing left. There’s nothing replenishing that fund.

In addition, each withdrawal from your IRA (assuming it consists of only deducted contributions and the growth) will be 100% taxed as ordinary income.

Lastly, your investments within the IRA are not generally guaranteed to retain value or grow over time. You might lose money in the account, further causing problems with the first characteristic of depleting the account. In other words, there is no guarantee that your IRA will continue to grow and provide you with inflation-adjusted withdrawals over time.

On the other hand, Social Security benefits are paid to you over your lifetime, as well as your spouse’s lifetime as mentioned above. (Let’s save the argument about the Trust Fund depletion for another time.)

Social Security is also very tax preferential; at a maximum, only 85% of each Social Security benefit payment is taxed as ordinary income. Depending on your overall income, you might even get by with something less being taxed, possibly even zero taxes on your Social Security.

Regarding inflation adjustment, Social Security benefits are adjusted annually (most of the time) to allow for increases in the cost of living. This is codified in the law, Congress and Social Security don’t have to take any action in order for this to happen, it’s automatic.

So with those factors all falling in favor of Social Security retirement benefits, why wouldn’t you want to maximize the benefit that you receive?

After an elbow to the ribs from Sherrie, Marc finally seemed to come to this same conclusion. After all, the retirement savings were set aside to help pay for their retirement. This very situation is exactly what they should be using that money for.

Readers, do you have a Social Security question? Email us at HelpMeRetire@marketwatch.com and we may use your question in a future column.

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