Social security benefits: timing is everything

CLAIMING SOCIAL SECURITY BENEFITSI was talking to a client a few weeks back who said to me, “What do I care? I get a raise at 62 anyway.” He was referring to filing and receiving his social security benefits at age 62 instead of waiting until his full retirement age (FRA). I had to quickly run through a few different scenarios with him and discuss why taking the benefits now instead of waiting may have an adverse effect on his long-term goals. It really resonated with me and made me wonder how many people have the same mindset as that client.

The basics

If you’re employed or self-employed, you are most likely paying into your social security benefits. In order to qualify for benefits when you retire, you need to have worked and paid into the social security system for 40 quarters, or 10 years. Your benefit is calculated based on a ratio of your 35 highest years of earnings, using zeroes for any year in which you did not work. There are spousal and survival benefits available, and even if divorced, you may qualify for benefits based on a former spouse’s earnings (restrictions may apply).

Back to the example

Now that we know the basics, let’s jump back to the example I mentioned earlier about my client taking benefits at 62. We will have to make a few assumptions in order to paint a proper picture. Putting aside whether or not there will be a social security system still around when my client retires (that’s a different conversation), let’s assume his FRA is 67 (this is important) and that he will live until 90 (lucky guy!). His FRA benefit is expected to be $24,000 a year, and for the sake of simplicity, we’ll assume no annual cost of living adjustment (COLA). Is this unrealistic? Probably – but there have been three years since 2010 with no COLA. We will also assume he is single and NOT working during the time period discussed, as working while collecting social security benefits can decrease the amount of benefits received.

If he begins collecting at 62 with an FRA of 67, he will have a 30% permanent reduction from his social security benefits. If he takes his benefits at 67 there will be no reduction, and if he waits until 70, he will receive a 24% increase in his benefits.

Breakdown of his monthly benefits

Claiming SSN chart 1

Approximate total payments he would receive over the course of his lifetime

Claiming SSN chart 2

Summary of his break-even ages when comparing the different options

Claiming SSN chart 3

As you can see from the information above, the various break-even points are ages that need to be reached in order for my client to receive the advantage of holding off on receiving his benefits. If he lives until age 78, then it was the right choice for him to hold off his benefits from 62 to 67, and if he lives until 82, then it was the right choice for him to hold off his benefits from 67 to 70.

(I’m not sure I need a disclaimer for a blog post, but obviously the example above was for illustrative purposes and should not be relied upon as a guarantee of benefits. Changing any of the variables above can have a drastic effect on the outcome of the example.)

So what’s the right answer?

It depends. I know that seems like a cop-out answer, but in order to know the right answer there are a host of variables that must be discussed with your advisors. Your health, lifestyle, family situation, and need/desire for the income all become factors that must be discussed and prioritized in order to maximize the benefits that you can receive.

No one has a crystal ball. When it is time to start thinking about filing for social security, you should reach out to your accountant and other trusted advisors to weigh your options.

joe_6Joseph DeMartinis is a Tax Supervisor in the firm’s Long Island office. He specializes in taxation of small and medium size businesses, their owners, inpatriates, expatriates, and high net worth individuals.


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The Dreaded “PFIC” Rules: How to Limit the Damage

Proceed with Caution

In a world that is becoming smaller, money-making opportunities present themselves all over the globe.  However, with said opportunity comes the obligation to pay taxes.  Otherwise prudent investors can find themselves in a precarious tax situation when they discover that they have been investing in what the U.S. tax rules refer to as “PFICs,” or Passive Foreign Investment Companies.  PFIC investments come with a unique set of compliance rules, and failure to meet these requirements can come with a hefty tax bill and/or penalties.

What is a PFIC?

There are two tests to determine if a foreign corporation falls into the PFIC category:

  • The Income Test: 75% or more of the corporation’s gross income for the taxable year is passive income. Passive income includes, but is not limited to, dividends, interest, royalties, rents, and annuities
  • The Assets Test: 50% or more of the corporation’s total assets are passive assets (based on average market value, or adjusted basis if qualified and elected)

How is a PFIC taxed?

So you determine that the foreign corporation is subject to PFIC rules.  There are three main ways the U.S. Government can tax a PFIC investment:

  • “Excess Distributions” Regime
  • Qualifying Elected Fund “QEF” Election
  • “Mark-to-Market” Election

By default, a PFIC will fall under the excess distribution method.  Tax recognition under this regime is not triggered by income earned but rather by distributions received. An excess distribution is a distribution that is greater than the base amount, defined as 125% of the average actual distributions received from the three prior years (or less, if owned for less time).  Once the base amount is determined, any part of the current year distribution that is above the base amount is considered excess.  The base amount is taxed as ordinary dividends, but the excess distribution is allocated to the entire holding period and taxed at the highest tax bracket for each year, thereby eliminating the deferral of yearly tax amounts.  There is also an interest charge associated with the excess distribution, calculated at the underpayment rate, which is the AFR short term rate plus 3%.  This would be considered a penalty regime, since you have been deferring foreign income from the U.S. Government, and as such they charge you interest to make up for it.  This default method is complex and cumbersome, to say the least.

Limiting the damage

Generally, the reporting for a PFIC is the responsibility of the first U.S. taxpayer owning the investment.  If this is the first year owning the PFIC, you can (and should – depending on your tax situation) make the QEF election to report all income currently.  A QEF election will treat the investment in the manner similar to that of a domestic mutual fund.  Your pro rata share of interest and dividends will be taxed at ordinary income tax rates and capital gains at the capital gains rate, even if you did not receive any distributions for the year.  Any distributions that you receive subsequently from the previously taxed income would be received tax free to you.  Important: a QEF election can generally only be made in the first year owning the investment.  There are retroactive elections and ways to “purge the PFIC taint,” thereby regaining the ability to make a QEF election, but those concepts are outside of the scope of this blog.  You should, however, be aware that they are available as a potential tax strategy.

If the QEF election cannot be made, another possibility to limit the damage would be the “Mark-to-Market” election.  This election was created to extend the current year income treatment that the QEF election offers for those investors that were unable to elect QEF.  If the PFIC stock is marketable (that’s an important qualification), you can elect to pick up the excess in fair market value over adjusted basis of the stock as ordinary income in the taxable year.  Your basis in the stock adjusts  accordingly in the year the income is recognized.  If there is a decrease in fair market value, losses can be taken to the extent of prior “unreversed inclusions”.  Prior unreversed inclusions are prior year mark-to-market gains that were previously picked up as income.  Any losses above and beyond the unreversed inclusions are lost.

The PFIC rules are extremely complicated, and we’ve only scratched the surface of navigating potential compliance issues.  If you think that you may have investments subject to the PFIC rules, you should reach out to a trusted professional to discuss your options.

joe_6Joseph DeMartinis is a Tax Supervisor in the firm’s Long Island office. He specializes in taxation of small and medium size businesses, their owners, inpatriates, expatriates, and high net worth individuals.