The Truth About the Earnings Test

You need to know how continuing to work will affect your benefits. The good news is that the reality isn’t nearly as nefarious as critics complain.

It sounds like a cruel joke: After a lifetime of working, you call it quits at 62, claim Social Security benefits and begin a long and satisfying retirement. Then you discover you can’t really afford to retire, so you go back to work. Your reward? The federal government cuts or completely suspends your Social Security benefits. Say hello to the confusing and controversial Social Security earnings test. Although the law says it’s fine to claim your benefits as early as age 62, you can’t necessarily collect the cash if you keep working.

The earnings test may cost a quarter of a million working Social Security beneficiaries more than $1 billion in forfeited benefits each year, according to a ballpark estimate Social Security officials made for Kiplinger. The agency told Congress that the earnings test will save Social Security $81 billion between 2012 and 2018 by allowing it to cut off benefits for beneficiaries who continue to work and by dissuading others from claiming benefits early. If you’re thinking of claiming benefits prior to your full retirement age (66 for those born between 1943 and 1954), you need to understand exactly what’s going on here. Fortunately, it’s not nearly as nefarious as the loudest critics claim.

How it really works

If you apply for Social Security prior to your full retirement age, you’ll be asked whether you plan to keep working and, if so, how much you expect to earn. Your answers determine whether and how severely you’ll be stung by the earnings test. For 2016, the test applies if you make more than $15,720. For every $2 you earn over that limit, you’ll lose $1 of benefits. Suppose you claim benefits at age 62, your monthly benefit is $1,500 and you estimate that you’ll earn $30,000 during the year. Because $30,000 is $14,280 over the limit, you would lose $7,140 in benefits—half of the amount by which your earnings exceed the limit.

Don’t assume that the Social Security Administration (SSA) will trim each check by a proportional amount. Instead, your benefits will be withheld completely until the squeeze is satisfied. In this example, you’d get no benefits for four months (holding back $6,000 of the lost benefits), and your benefit in the sixth month would be $1,500 minus the final $1,140 claimed by the earnings test, or just $360.

In the year you first claim benefits, a special monthly earnings test can apply. Basically, for any month after you apply that you earn less than $1,310 (one-twelfth of 2016’s annual limit), you’ll get 100% of your benefit; if you make more, however, you’ll lose 100% of your benefit for that month. (For self-employed workers, a different, more complicated rule applies for the first year you claim benefits. It involves the number of hours you work each month in your business. In the year you reach your full retirement age, a more lenient earnings test applies: You lose $1 for every $3 in earnings over $41,880 before your birthday. Starting in the month you reach your full retirement age, there’s no earnings test. You can earn as much as you want without losing a dime in benefits.

Note this: For purposes of the earnings test, only wages from a job or self-employment income count. Investment earnings, pension benefits, money drawn from an IRA or 401(k)—even lottery winnings—do not.

Not the honor system

Although the earnings-test squeeze is initially based on your estimate of your earnings, that projection isn’t the final word. When you file your tax return, the IRS lets the SSA know exactly how much wage and self-employment earnings you report. That figure is compared with your estimate, and the government reconciles the books by sending you a check—if your estimate was too high and too much of your benefits was withheld—or dunning you for a balance due. This final point is particularly important if you unexpectedly return to work after you claim benefits and before your full retirement age, making you subject to the earnings test. You should let the SSA know about the change in circumstances as soon as possible so that your benefits can be trimmed if you run afoul of the earnings test. Failing to do so could come back to haunt you later. If the tax return you file shows earnings that should have triggered reduced benefits, you’ll be asked to pay back the excess in a lump sum or see future benefits reduced to true up the books.

About the Author Doug Finley

Douglas Finley, MS, CFP, AEP, CDFA founded Finley Wealth Advisors in February of 2006, as a Fiduciary Fee-Only Registered Investment Advisor, with the goal of creating a firm that eliminated the conflicts of interest inherent in the financial planner – advisor/client relationship. The firm specializes in wealth management for the middle-class millionaire.

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