A financial adviser wrote to me recently asking how to interpret the Social Security estimated-benefits statement of one of his new clients, a veteran firefighter of more than 30 years.
The client's public-sector job is not covered by Social Security, but over the years, he has worked some side jobs and paid FICA taxes. He will receive a government pension from his firefighter job.
A review of the client's Social Security estimated-benefits statement showed several years where he had no earnings subject to Social Security taxes and a few years where he had a few hundred to a few thousand dollars of covered earnings. The statement said his estimated Social Security benefit at full retirement age is $1,480 a month.
The adviser wants to know if he can count on the estimated Social Security benefits when calculating his client's retirement plan.
No way.
(More: Don't get greedy with Social Security strategies)
If you have a client who has worked for an employer that does not withhold Social Security taxes, such as a government agency or an employer in another country, any pension they receive based on that work may reduce their Social Security benefits.
The Windfall Elimination Provision affects how the amount of a retirement or disability benefit is calculated. WEP rules affect primarily those who earned a pension in any job where they did not pay Social Security taxes and who also worked in other jobs long enough to qualify for a Social Security retirement or disability benefit (a minimum of 10 years or 40 quarters).
A separate rule, known as the Government Pension Offset, can reduce Social Security spousal and survivor benefits of a worker who collects a pension from work not covered by Social Security by two-thirds of the amount of the pension.
But because the Social Security Administration doesn't know if that person is entitled to such a pension, the estimated-benefit statement does not reflect the potential reductions.
Social Security benefits are based on the worker's top 35 years of average monthly earnings, adjusted for inflation, and are intended to replace only a percentage of a worker's pre-retirement earnings. Lower-paid workers get a higher return than highly paid workers. For example, lower-paid workers could get a Social Security benefit that equals about 55% of their pre-retirement earnings, while the average replacement rate for highly paid workers is about 25%.
Before major Social Security reforms were adopted in 1983, people who worked mainly in a job not covered by Social Security, as well as side jobs where they paid FICA taxes, had their Social Security benefits calculated as if they were long-term, low-wage workers. They had the advantage of receiving a Social Security benefit representing a higher percentage of their earnings, plus a pension from a job where they did not pay Social Security taxes. Congress passed the WEP rules to remove that advantage.
The WEP reduction is limited to one-half of the pension from noncovered work but could be lower. In 2014, the reduction generally can't exceed $408 per month. So if, for example, your client's estimated Social Security benefit is $1,408 at full retirement age, after the WEP reduction, he receives $1,000 per month.
However, the WEP reduction may be larger if family members, such as a spouse or dependent minor children, qualify for benefits on the worker's record.
(Related: Social Security benefits subject to a family maximum limit)
Clients who paid Social Security taxes on 30 years of “substantial earnings” are not affected by WEP reductions. Neither are survivor benefits, so when the firefighter dies, his widow will be able to collect survivor benefits based on his Social Security benefits before the WEP reduction was applied.
Back in 1983, when the firefighter started his job, substantial earnings were defined as $6,675 a year and have been increased annually ever since. Today, substantial earnings are considered $21,750 per year.
