The Perils of the Earnings Test

(TheStreet) - Inflation, economic downturns, COVID-19-related job losses, health issues, and debt management are too often the realities of our times. When these types of changes happen to individuals, it might make sense to supplement incomes by starting Social Security benefits early, before full retirement age.

Generally, there are two primary reasons to take Social Security before full retirement age: financial need and poor health. Adding about $2,500 in monthly cash flow could very well take the edge off the need for more income. With Social Security, you don’t have to apply for a loan. There is no repayment needed because the Social Security benefits were pre-funded by FICA taxes paid into the system for over 35 working years. To make it even easier, now you can just file for benefits online on the Social Security Administration’s website, without the need to visit with a counselor or see a loan officer.

However filing for Social Security benefits early is a double-edged sword. Yes, you can collect the money early, which might be a good idea based on existing urgent or unexpected economic needs. But by taking benefits early, you could potentially reduce the amount of your lifetime income.

Still, in these unusual times, Social Security benefits are waiting for workers who need them immediately. There is an important rule regarding taking benefits before full retirement age that must always be considered before making an early filing decision: What happens if you're still working? In this case, the Social Security Administration’s earnings test becomes a serious roadblock that must be considered.

In 2022, the earnings test for people under the year of their full retirement age is $19,560, meaning that the earnings test will not be applied if one is currently working and making less than the specified amount. The earnings test starts when benefits start and apply to all types of Social Security benefits taken before full retirement age, including regular retirement benefits, spousal benefits, and survivor benefits. For workers earning more than $19,560, for every $2 over $19,560, $1 in benefits is withheld from the worker.

For the first year, there is a special way the earnings test is applied. It is calculated by the month rather than by the year. The special earnings test helps workers who start their payments in mid-year. Once the benefits start, in the first year, if you make $1,630 a month or less, there is no earnings test. If your monthly income is higher than $1,630, the benefit is withheld. After the first year, the earnings test is applied annually.

The bar for the earnings test becomes a little higher in the year of full retirement age. In that year the earnings threshold increases to $51,960 or $4,330 a month. In addition, the amount withheld is now $1 for every $3 earned over the threshold.

For employees, wages when they are earned (not paid), are counted in the earnings test formula. Distributions from qualified plans, rent, royalties, capital gains, and other types of unearned income are excluded from the test.

For self-employed workers, the rules are similar, but also have their own differences. Only net, self-employed, income counts. Business expenses are deducted before the earning test threshold formula is applied. For the self-employed, the earnings test formula is applied when the money is received, not when it is earned.

The self-employed also have another hurdle to remember when applying for benefits early— time on the job. The Social Security Administration (SSA) considers that if one is working 45 hours per month or more, one is not retired. To be considered retired, one must work less than 15 hours per month. To make it even more of a challenge, if the self-employed job is very specialized or if you are running a “good-sized” company, working between 15 and 45 hours per month will also trigger the earnings test formula.

A reasonable question should be asked about the withheld benefits: What happens to them? Here is the good news—they are not lost. At full retirement age, the amount of the withheld benefits is recalculated and the worker's monthly benefit checks are increased to start the payback. The withheld benefits are gradually paid back to the worker over their projected lifetime, not in one lump sum. Therefore, you must live long enough to recapture all the withheld dollars.

Workers are often surprised by the earnings test rules. If they did not understand that working before full retirement age is a problem, they are often shocked when the letter from the Social Security Administration arrives asking for a large amount of money back!

How Does This Happen? 

When a worker receives benefits, it generates an IRS form 1099. This form is then filed each year when income taxes are due. The IRS computers are programmed to communicate with the SSA when there has been an earnings test violation and that, in turn, generates the letter. Imagine the reaction to a request from the SSA asking for $12,000 or more back in a lump sum because earned income was too high in the previous year.

The earnings test also complicates things when filing for either spousal or survivor benefits. Remember, this test applies to all types of Social Security income received before full retirement age.

Let’s use an example here— Mary, age 60, loses her husband, Bob. Bob’s full retirement age benefit is $3,000 a month. Mary would like to take the reduced survivor benefit now and continue to work. Her income of $85,000 a year disqualifies her from a benefit until she reaches her full retirement age.

At her full retirement age, she can take the survivor benefit and defer her own. At age 70, delayed retirement credits have increased her own benefit and it would pay to switch over to her own record and stop the benefits from Bob. This is the classic restricted filing strategy, and it is allowed when collecting survivor benefits.

The earnings test is well-described in the SSA publication, “What Happens When You Work?” Give it a look. Remember that each year, both of the earnings thresholds increase, so it is important to keep up-to-date with the most accurate threshold numbers.

Social Security benefits can easily work their way into any budget. Once there, the money tends to support multiple lifestyle needs. If they are suddenly stopped, the shock to the system can be significant and troubling. The earnings test must be part of the planning process to avoid a big surprise later!

By David G. Freitag, CLU
August 24, 2022

About the Author: David G. Freitag, CLU®, ChFC®, CRPC

David G. Freitag is an industry veteran in financial services and wealth management. He brings a deep passion and unparalleled expertise in Social Security filing strategies and retirement income planning to his current role as a financial planning consultant with Massachusetts Mutual Life Insurance Company (MassMutual). David holds Chartered Life Underwriter, Chartered Financial Consultant, Chartered Retirement Planning Consultant designations, and his Series 7 and 24 securities licenses. He also holds a Master of Education and Bachelor of Science degrees from the University of Maryland.


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