In the current economic environment, one of the greatest challenges faced by financial advisors is how to boost income for retired, risk-averse clients.
Certificates of deposit and immediate annuities certainly sit on the safer side of the investment spectrum. However, the income provided is so low that clients might as well put their principal in a jar, and pull it out on a monthly basis until the jar is empty.
Clients looking for more monthly money might be better off with a more esoteric strategy: using some of their assets to pay back the Social Security benefits they've previously received, and re-file for benefits at their current age
Current recipients of Social Security retirement benefits can file SSA Form 521, entitled “Withdrawal of Application.” Upon repayment of their benefits (as well as any spousal benefits paid), the client will begin receiving a new, higher payment based on the client's new, higher age of initiation.
Sharp-eyed readers will note the “repayment of benefits” part of the preceding paragraph. Yes, the clients have to repay all the money they've received in one lump sum. The good news is that there is no interest charged on the benefits they have received in the past.
The better news is that clients may be eligible to get a refund of income taxes that were incurred on the original payments. And the best news is that their new Social Security check amount may be wildly higher than their old one.
Say a 70-year-old client originally initiated Social Security upon turning 62, for an amount of $1,000 per month. We'll ignore any cost-of-living increases, since such bumps up are usually minimal, and applied regardless of the age of initiation.
In the intervening years, the client has received $96,000 in Social Security payments ($1,000 × 12 months × 8 years). After checking with the people in the Social Security office, he finds out that if he withdraws his application and re-files for his benefits, his new monthly check will be $1,760.
The actual rate of return received on repaying his benefits depends mainly on how long he lives — and collects those higher benefits.
But for example, if your client withdraws his application, repays the $96,000 received, starts over with a new monthly check of $1,736 and lives to 85, the effective annualized rate of return on the $96,000 will be 4.26 percent over the 15-year period.
Of course, that considerable rate rises even higher the longer your client lives (or beyond, if after he dies, his surviving spouse keeps collecting a check in the same amount). Conversely, the earlier your client dies, the lower the annual return and the less attractive the strategy becomes.
Such a remarkable prospective return should make the strategy an obvious choice over other lower-risk investments, such as the aforementioned certificates of deposit and immediate annuities.
However, handing over a near-six-figure sum to the good people in the Social Security Administration is not without risks, especially when compared with these other mundane alternatives.
First, CD buyers will likely get a lower rate of return than those who pursue the repayment strategy. But CD owners also get their principal returned at maturity, and in the event of an emergency in the meantime, they may be able to get access to the lion's share of the deposit before it actually matures.
Buyers of immediate annuities generally have no such option. However, they can guarantee that the payments will continue for a minimum amount of time that may last far longer than the client does. Plus, a good portion of the payment may be a tax-free return of principal.
But that tax-advantaged payment may not be equal to the boost available from repaying Social Security. According to www.immediateannuities.com, a 70-year-old male depositing $96,000 could receive about $689 per month guaranteed for as long as he lives. That amount drops down to $546 per month if he wants the payment to go to a surviving spouse of the same age, an option already built in to his higher Social Security benefit.
And even in the worst-case scenario, only 85 percent of the new higher Social Security payment will be counted as taxable income. If the client has little or no other outside income, the payments may be completely free from taxation (see IRS Publication 915 for more information).
Since with even simple math the hypothetical client discussed above needs to reach the age of 81 just to “break even” on the repayment proposition, the wisdom of the strategy rises with the client's life expectancy. So it's best used for clients in better health.
But particularly pessimistic clients may be surprised to know that according to the Social Security Administration's Actuarial Life Table (available at www.ssa.gov), a 70 year-old male has an average life expectancy of 83.5 years, and his female counterpart's number is 86.
Naturally, the client also needs enough accessible money to repay the benefits. But he should also have other liquid sources of funds to cover any larger unexpected expenses that can't be covered by the new, higher Social Security payment.
Preferably, that cache of cash will be outside of a retirement account, so that a larger withdrawal won't trigger a larger tax bill. But clients should also have a home equity line of credit established to cover themselves in a pinch.
Finally, the clients most suited for repaying and refiling for their benefits are ones who are likely to be in a similar (or lower) tax bracket in the future than they were when they collected the checks in the past.
An Added Benefit
One strategy that you and your client can use to reduce the chances that their larger Social Security payment is going to generate a much larger tax bill is to combine the withdrawal of the benefits application with conversion of an IRA to a Roth IRA.
Besides being exempt from income taxes and having no mandatory withdrawal date while the owner is alive, Roth IRAs enjoy a unique, little-known feature in that distributions from Roth IRAs aren't included when determining if Social Security benefits are taxable.
So the client can suspend and repay his benefits, convert some or all of his IRAs to Roth IRAs, and then re-start the payments. Not only will he get a higher check, but he will likely owe much less in income taxes on the payments in the future.
CFP© is Principal/Owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book Make Your Kid a Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. Find out more at www.advisortipsheet.com.