Your Social Security math may be wrong — and it could cost you a lot of money

Your Social Security math may be wrong — and it could cost you a lot of money

When the topic of retirement planning arises, it’s not uncommon for someone nearing retirement age to share their Social Security claiming plan and how they arrived at it. However, the logic behind these plans is often flawed. The implications of these flawed plans can be significant, leading to a loss of tens of thousands — if not more — of their hard-earned dollars.

As a retirement planner, when I overhear these conversations, I’m often at odds with what to do. Should I smile and nod, allowing them to make a mistake that may cost them money? Or dare I risk sounding like a know-it-all, never-to-be-invited-again to said social group and explain the flaw in their logic? While I know Social Security claiming strategies, I haven’t yet discovered the secret to navigating these delicate social interactions.

However, I have discovered three common mistakes within the Social Security “napkin math” that people do at home. By understanding these, you can avoid these errors in your analysis.

Let’s look at Wanda Worker, age 62, whose sample Social Security statement is available online with a quick Google search. Per this statement, Wanda can receive $1,465 monthly if claiming at 62 and $2,119 if she claims at age 67, her full retirement age (FRA).

Wanda is aware that if she claims before her FRA, this will subject her to the earnings limit, and as she plans to continue to work, that would result in a reduction in benefits. Understanding these implications is crucial for her to make an informed decision about her Social Security benefits, as she knows that age 67 is the earliest she would consider claiming.

Wanda calculates that if she lives to 85, she’ll receive $483,132 in benefits ($2,119 x 12 x 19 years). Her Social Security statement tells her she’ll receive $2,634 if she waits until 70 to start benefits. By her estimates, that is $2,634 x 12 x 16 years, or $505,728 in benefits. Sure, it’s slightly more than if she claims at 67, but she’ll have to forego three years of $2,119 a month or $76,284 to get that extra $515 a month. That’s just over 143 months, or 11.85 years to break even. That means if Wanda claims at 70, she needs to live about 12 years to 82 to recoup the $76,284 she didn’t receive from 67 through 70.

If she retires at 67, she can travel while she is active and able. She views Social Security as an income source that can help fund that. If she doesn’t start benefits at 67, she’ll have to use her personal savings to fund these expenses and the thought of spending some of those funds is scary. In her mind, a break-even age of 82 seems a long way off, and she figures claiming at 67 and preserving her savings is a prudent decision based on her financial circumstances.

Wanda’s logic is missing three key pieces of information: the inflation adjustment to Social Security, the longevity odds, and the nuances of the tax code.

Read: Forget about your retirement portfolio beating inflation over the next 10 years

Inflation

The inflation adjustments that occur will provide a bigger boost to delaying benefits than you may realize. Here’s why. While your Social Security statement estimates what you will receive in the future those estimates are in nominal terms, not real. An annual cost-of-living adjustment, or COLA, will be applied to the benefit amounts listed on the statement. Although you may think it will impact each benefit amount equally, it doesn’t work out that way.

Based on Wanda’s statement, the $515 a month more she can get at 70 is 24% more than the $2,119 she can receive at 67. But if a 2% COLA applies, Wanda’s future choices will be $2,340 at age 67 or $3,086 at age 70, a $747 difference, or 32% more at age 70.

How likely is a 2% COLA? Social Security benefits increased by 5.9% in 2022, 8.7% in 2023, and 3.2% in 2024, yet were zero in 2010, 2011, and 2016, as each year’s increase is calculated based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) from the third quarter of the prior year. The long-term average indicates a 2% or higher COLA is quite realistic.

Your statement doesn’t project these increases because no one knows precisely what they will be. But we know that if you start later, you get a larger amount; thus, any increase will apply to a bigger base. The result is that unless we have many years of 0% inflation, starting Social Security later has more horsepower than simple napkin math may indicate.

Read: Social Security’s COLA could be lower in 2025 amid cooling inflation

Longevity

Wanda, like many people, is miscalculating the odds of living past 82. Here’s how this easily happens.

When you search statistics on average life expectancy, you’ll find estimates ranging from about 76 to 78 years for a U.S.-born person. However, that number is calculated from birth. The longer you live, the longer you are expected to live. A 65-year-old woman can expect to live 19.7 more years, on average. A white-collar worker can add one to three years to those estimates. Since Wanda has already made it this far, that puts her average life expectancy closer to the 85 to 87 range.

Let’s hope Wanda sees these statistics and realizes that, unless she has life-shortening health conditions, by claiming at 70, she has an opportunity to bet against the house with winning odds.

Those odds may get even more favorable if Wanda is married. Due to the survivor benefit feature embedded in Social Security, married couples should consider joint longevity when making claiming decisions. For married couples receiving Social Security, only the higher benefit amount of the two continues when the first spouse passes. This makes it critical to supersize the benefit amount for one of the spouses, usually the higher earner, but not as crucial to maximizing the benefit amount for both.

The longer you live, the greater the return on choosing a later start to your benefits. This is one of the few financial decisions you can make that protects you from outliving your money and has inflation protection to boot.

Read: Here’s what Trump and Biden got wrong about Social Security during the first debate

Taxes

Wanda is not factoring taxes into her analysis. While many people understand that some of their Social Security benefits will be tax-free, they don’t understand the complex formula for calculating this portion. If Social Security composes a larger share of your total income, it is likely more of it will be tax-free.

Let’s use two twins as an example. Twin 1 has a retirement income with $28,000 in Social Security and $47,000 in IRA withdrawals. Twin 2 has $37,000 in Social Security and $38,000 in IRA withdrawals. Both have $75,000 of gross income and the standard and additional age 65 deductions.

Twin 1 owes $6,994 in taxes for the 2024 year. Twin 2 owes $5,177 in taxes. Why the difference? Because Social Security makes up a larger portion of Twin 2’s income, less of that income is taxable, resulting in $70,800 of taxable income for Twin 1 and $61,625 for Twin 2.

This example illustrates how delaying Social Security so a larger portion of your future income is taxed more favorably can potentially compound into thousands of tax savings over your lifetime. The problem is that when claiming Social Security, most aren’t considering taxes at all, and they should be. Of course, a personalized calculation is needed to see how the tax code works in your situation.

While napkin math can be great for estimating how many pounds of hamburger to buy for the weekend barbecue, it isn’t advised when it comes to irrevocable decisions that impact income for the rest of your life. You need retirement-plan calculations that include inflation, longevity, and taxes.

Whether you navigate the math on your own or with help, this is the time to measure twice and cut once because once your retirement plan is in motion, it isn’t easy to change it.

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