Escape hatch for workers claiming Social Security early

Dramatic stock market losses and soaring unemployment rates resulting from the worldwide coronavirus pandemic have prompted some older workers to rethink their Social Security claiming strategies. Many wonder if they can file for benefits early even if their earnings have already exceeded annual limits.

“I’m working with someone who has decided to take their Social Security retirement benefit prior to their full retirement age,” an adviser from Omaha wrote to me in an email. “How do I estimate how much his benefits will be reduced since his earnings for the year have already exceeded Social Security’s annual limit?”

Individuals who file for Social Security benefits before their full retirement age are subject to benefit reductions for claiming early, as well as reductions if their earnings from a job or self-employment exceed annual limits. But there is a special first year in retirement rule that can ease that blow.

In 2020, someone who is under full retirement age for the entire year would lose $1 in benefits for every $2 earned over $18,240. In the year an individual reaches full retirement age, there is a more generous test. People who turn 66 in 2020 can earn up to $48,600 in the months before their birthday and would lose just $1 in benefits for every $3 earned over that limit.

The earnings restrictions disappear at full retirement age, which means individuals could earn any amount of money without forfeiting any Social Security benefits once they reach full retirement age.

But a special first year in retirement rule designed for people who retire at midyear who have already earned more than the annual earnings limit could help high-earning clients who lose a job due to the pandemic and want to claim Social Security before their full retirement age to replace some lost income.

The Social Security Administration counts only the wages you make from your job, including bonuses, commissions and vacation pay, or your net profit if you're self-employed, in its earnings test. It doesn’t include pensions, annuities, investment income, interest or other government or military retirement benefits in the earned income calculation. Nor does it count unemployment benefits.

SSA provides a helpful calculator to estimate the impact of the earnings cap. Here's an example from that calculator.

Let’s assume you have a 64-year-old client who earned $30,000 in 2020 before losing his job in April. His reduced retirement benefit would be $2,000 per month if he claimed benefits now, two years and four months before his full retirement age. Normally, his benefit could be further reduced by his excess earnings.

Because his $30,000 in earnings exceeded the annual limit of $18,240, his Social Security benefits would be reduced by $5,880. ($30,000 -$18,240 = $11,760/2 = $5,880). Social Security would withhold three months of benefits ($2,000 x 3 = $6,000) to satisfy the excess earnings rule. The following year, SSA would refund any excess benefits withheld, which in this example would be $120 ($6,000 - $5,880).

But if all of his earnings occurred before the first month that he received Social Security benefit, his benefits would not be affected by the retirement earnings test. Social Security would consider this client retired as long as his monthly earned income did not exceed $1,520 ($18,240/12) in 2020 and he didn't perform “substantial services” in self-employment, defined as devoting more than 45 hours a month to a business.

The same first year in retirement rule would apply to someone who turns 66 in 2020 if their earnings exceeded the higher annual limit of $48,600 in the months before their birthday. Social Security would consider that person retired and eligible for benefits as long as their earnings did not exceed $4,050 ($48,600/12) a month in the months before they reach full retirement age.

Here’s another example from the Social Security website that illustrates how self-employment income can affect the first year in retirement rule.  

John Smith retires at age 62 on June 30, 2020. He earned $37,000 before he retired. On Oct. 5, John starts his own business. He works at least 15 hours a week for the rest of the year and earns an additional $3,000 after expenses. His total earnings for 2020 are $40,000.

Although his earnings for the year substantially exceed the 2020 annual limit ($18,240), John will receive a Social Security payment for July, August and September. This is because he was not self-employed and his earnings in those three months are $1,520 or less per month.

[More: Social Security 5 Year Rule: The trick of Social Security in first year of retirement]

John will not receive benefits for October, November or December 2020 because he worked in his business over 45 hours per month in all three months.

Beginning in 2021, the deductions will be based solely on John's annual earnings limit.