Financial Information

Nearly 45 million people today receive some form of Social Security benefits, including 90 percent of retired workers over age 65. But Social Security is more than just a retirement program. Its scope has expanded to include other benefits as well, such as disability, family, and survivor’s benefits.

How does Social Security work?

The Social Security system is based on a simple premise: Throughout your career, you pay a portion of your earnings into a trust fund by paying Social Security or self-employment taxes. Your employer, if any, contributes an equal amount. In return, you receive certain benefits that can provide income to you when you need it most–at retirement or when you become disabled, for instance. Your family members can receive benefits based on your earnings record, too. The amount of benefits that you and your family members receive depends on several factors, including your average lifetime earnings, your date of birth, and the type of benefit that you’re applying for.

Your earnings and the taxes you pay are reported to the Social Security Administration (SSA) by your employer, or if you are self-employed, by the Internal Revenue Service. The SSA uses your Social Security number to track your earnings and your benefits.

Finding out what earnings have been reported to the SSA and what benefits you can expect to receive is easy. Just check out your Social Security Statement, mailed by the SSA annually to anyone age 25 or older who is not already receiving Social Security benefits. You’ll receive this statement each year about three months before your birthday. It summarizes your earnings record and estimates the retirement, disability, and survivor’s benefits that you and your family members may be eligible to receive. You can also order a statement at the SSA website, at your local SSA office, or by calling (800) 772-1213.

Social Security eligibility

When you work and pay Social Security taxes, you earn credits that enable you to qualify for Social Security benefits. You can earn up to 4 credits per year, depending on the amount of income that you have. Most people must build up 40 credits (10 years of work) to be eligible for Social Security retirement benefits, but need fewer credits to be eligible for disability benefits or for their family members to be eligible for survivor’s benefits.

Your retirement benefits

If you were born before 1938, you will be eligible for full retirement benefits at age 65. If you were born in 1938 or later, the age at which you are eligible for full retirement benefits will be different. That’s because full retirement age is gradually increasing to age 67.

But you don’t have to wait until full retirement age to begin receiving benefits. No matter what your full retirement age, you can begin receiving early retirement benefits at age 62. Doing so is often advantageous: Although you’ll receive a reduced benefit if you retire early, you’ll receive benefits for a longer period than someone who retires at full retirement age.

You can also choose to delay receiving retirement benefits past full retirement age. If you delay retirement, the Social Security benefit that you eventually receive will be as much as 6 to 8 percent higher. That’s because you’ll receive a delayed retirement credit for each month that you delay receiving retirement benefits, up to age 70. The amount of this credit varies, depending on your year of birth.

Disability benefits

If you become disabled, you may be eligible for Social Security disability benefits. The SSA defines disability as a physical or mental condition severe enough to prevent a person from performing substantial work of any kind for at least a year. This is a strict definition of disability, so if you’re only temporarily disabled, don’t expect to receive Social Security disability benefits–benefits won’t begin until the sixth full month after the onset of your disability. And because processing your claim may take some time, apply for disability benefits as soon as you realize that your disability will be long term.

Family benefits

If you begin receiving retirement or disability benefits, your family members might also be eligible to receive benefits based on your earnings record. Eligible family members may include:

• Your spouse age 62 or older, if married at least 1 year
• Your former spouse age 62 or older, if you were married at least 10 years
• Your spouse or former spouse at any age, if caring for your child who is under age 16 or disabled
• Your children under age 18, if unmarried
• Your children under age 19, if full-time students (through grade 12) or disabled
• Your children older than 18, if severely disabled

Each family member may receive a benefit that is as much as 50 percent of your benefit. However, the amount that can be paid each month to a family is limited. The total benefit that your family can receive based on your earnings record is about 150 to 180 percent of your full retirement benefit amount. If the total family benefit exceeds this limit, each family member’s benefit will be reduced proportionately. Your benefit won’t be affected.

Survivor’s benefits

When you die, your family members may qualify for survivor’s benefits based on your earnings record. These family members include:

• Your widow(er) or ex-spouse age 60 or older (or age 50 or older if disabled)
• Your widow(er) or ex-spouse at any age, if caring for your child who is under 16 or disabled
• Your children under 18, if unmarried
• Your children under age 19, if full-time students (through grade 12) or disabled
• Your children older than 18, if severely disabled
• Your parents, if they depended on you for at least half of their support

Your widow(er) or children may also receive a one-time $255 death benefit immediately after you die.

Applying for Social Security benefits

You can apply for Social Security benefits in person at your local Social Security office. You can also begin the process by calling (800) 772-1213 or by filling out an on-line application on the Social Security website. The SSA suggests that you contact its representative the year before the year you plan to retire, to determine when you should apply and begin receiving benefits. If you’re applying for disability or survivor’s benefits, apply as soon as you are eligible.

Depending on the type of Social Security benefits that you are applying for, you will be asked to furnish certain records, such as a birth certificate, W-2 forms, and verification of your Social Security number and citizenship. The documents must be original or certified copies. If any of your family members are applying for benefits, they will be expected to submit similar documentation. The SSA representative will let you know which documents you need and help you get any documents you don’t already have.

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When it comes to planning for your retirement income, it’s easy to overlook some of the common factors that can affect how much you’ll have available to spend.  If you don’t consider how your retirement income can be impacted by investment risk, inflation risk, catastrophic illness or long-term care, and taxes, you may not be able to enjoy the retirement you envision.

Investment Risk

Different types of investments carry with them different risks.  Sound retirement income planning involves understanding these risks and how they can influence your available income in retirement.

Investment or market risk is the risk that fluctuations in the securities market may result in the reduction and/or depletion of the value of your retirement savings.

If you need to withdraw from your investments to supplement your retirement income, two important factors in determining how long your investments will last are the amount of the withdrawals you take and the growth and/or earnings your investments experience.  You might base the anticipated rate of return of your investments on the presumption that market fluctuations will average out over time, and estimate how long your savings will last based on an anticipated, average rate of return.

Unfortunately, the market doesn’t always generate positive returns. Sometimes there are periods lasting for a few years or longer when the market provides negative returns.  During these periods, constant withdrawals from your savings combined with prolonged negative market returns can result in the depletion of your savings far sooner than planned.

Reinvestment risk is the risk that proceeds available for reinvestment must be reinvested at an interest rate that’s lower than the rate of the instrument that generated the proceeds.  This could mean that you have to reinvest at a lower rate of return, or take on additional risk to achieve the same level of return.  This type of risk is often associated with fixed interest savings instruments such as bonds or bank certificates of deposit.  When the instrument matures, comparable instruments may not be paying the same return or a better return as the matured investment.

Interest rate risk occurs when interest rates rise and the prices of some existing investments drop.  For example, during periods of rising interest rates, newer bond issues will likely yield higher coupon rates than older bonds issued during periods of lower interest rates, thus decreasing the market value of the older bonds.  You also might see the market value of some stocks and mutual funds drop due to interest rate hikes because some investors will shift their money from these stocks and mutual funds to lower-risk fixed investments paying higher interest rates compared to prior years.

Inflation risk

Inflation is the risk that the purchasing power of a dollar will decline over time, due to the rising cost of goods and services.  If inflation runs at its historical average of about 3%, the purchasing power of a given sum of money will be cut in half in 23 years.  If it jumps to 4%, the purchasing power is cut in half in 18 years.

A simple example illustrates the impact of inflation on retirement income. Assuming a consistent annual inflation rate of 3%, and excluding taxes and investment returns in general, if $50,000 satisfies your retirement income needs this year, you’ll need $51,500 of income next year to meet the same income needs. In 10 years, you’ll need about $67,195 to equal the purchasing power of $50,000 this year.  Therefore, to outpace inflation, you should try to have some strategy in place that allows your income stream to grow throughout retirement.

This hypothetical example is for illustrative purposes only and assumes a 3% annual rate of inflation without considering taxes.  It does not reflect the performance of any particular investment.

Long-term expenses

Long-term care may be needed when physical or mental disabilities impair your capacity to perform everyday basic tasks.  As life expectancies increase, so does the potential need for long-term care.  And the cost of care is growing at a rate faster than inflation. (Source: The National Clearinghouse for Long-Term Care Information, 2007)

Paying for long-term care can have a significant impact on retirement income and savings, especially for the healthy spouse.  While not everyone needs long-term care during their lives, ignoring the possibility of such care and failing to plan for it can leave you or your spouse with little or no income or savings if such care is needed.  Even if you decide to buy long-term care insurance, don’t forget to factor the premium cost into your retirement income needs.

The costs of catastrophic care

As the number of employers providing retirement health-care benefits dwindles and the cost of medical care continues to spiral upward, planning for catastrophic health-care costs in retirement is becoming more important.  If you recently retired from a job that provided health insurance, you may not fully appreciate how much health care really costs.

Despite the availability of Medicare coverage, you’ll likely have to pay for additional health-related expenses out-of-pocket.  You may have to pay the rising premium costs of Medicare optional Part B coverage (which helps pay for outpatient services) and/or Part D prescription drug coverage. You may also want to buy supplemental Medigap insurance, which is used to pay Medicare deductibles and co-payments and to provide protection against catastrophic expenses that either exceed Medicare benefits or are not covered by Medicare at all.  Otherwise, you may need to cover Medicare deductibles, co-payments, and other costs out-of-pocket.

Taxes

The effect of taxes on your retirement savings and income is an often overlooked but significant aspect of retirement income planning.  Taxes can eat into your income, significantly reducing the amount you have available to spend in retirement.

It’s important to understand how your investments are taxed.  Some income, like interest, is taxed at ordinary income tax rates.  Other income, like long-term capital gains and qualifying dividends, currently benefit from special–generally lower–maximum tax rates.  Some specific investments, like certain municipal bonds, generate income that is exempt from federal income tax altogether.  You should understand how the income generated by your investments is taxed, so that you can factor the tax into your overall projection.

Taxes can impact your available retirement income, especially if a significant portion of your savings and/or income comes from tax-qualified accounts such as pensions, 401(k)s, and traditional IRAs, since most, if not all, of the income from these accounts is subject to income taxes.  Understanding the tax consequences of these investments is vital when making retirement income projections.

Have you planned for these factors?

When planning for your retirement, consider these common factors that can affect your income and savings.  While many of these same issues can affect your income during your working years, you may not notice their influence because you’re not depending on your savings as a major source of income. However, investment risk, inflation, taxes, and health-related expenses can greatly affect your retirement income.

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One of the main reasons we buy life insurance is so that when we die, our loved ones will have enough money to pay off our remaining debts and final expenses.  We also purchase life insurance to provide for our loved ones’ future living expenses, at least for a while.  That’s why it may seem unfair that life insurance proceeds can be reduced by estate taxes.  That’s right–the general rule is that life insurance proceeds are subject to federal estate tax (and, depending on your state’s laws, state estate tax as well).  This means that as much as 45% of your life insurance proceeds could be going to Uncle Sam instead of to your family as you intend.  Fortunately, proper planning can help protect your family’s financial security.

The key is ownership

Generally, all the property you own at your death is subject to federal estate tax.  The important point here is that estate tax is imposed only on property in which you have an ownership interest; so if you don’t own your life insurance, the proceeds will generally avoid this tax.  This begs the question: Who should own your life insurance instead?  For many, the answer is an irrevocable life insurance trust, or ILIT (pronounced “eye-lit”).

Tip: Generally, each of us has a lifetime estate tax exemption (currently $2 million), so only individuals with estates that exceed this exemption amount need to be concerned about planning for estate tax.

What is an ILIT?

An ILIT is a trust primarily set up to hold a life insurance policy.  The main purpose of an ILIT is to avoid federal estate tax.  If the trust is drafted and funded properly, your loved ones should receive all of your life insurance proceeds, undiminished by estate tax.

How an ILIT works

Because an ILIT is an irrevocable trust, it is considered a separate entity.  If your life insurance policy is held by the ILIT, you don’t own the policy–the trust does.

You name the ILIT as the beneficiary of your life insurance policy.  (Your family will ultimately receive the proceeds because they will be the named beneficiaries of the ILIT.)  This way, there is no danger that the proceeds will end up in your estate.  This could happen, for example, if the named beneficiary of your policy was an individual who dies, and then you die before you have a chance to name another.

Because you don’t own the policy and your estate will not be the beneficiary of the proceeds, your life insurance will escape estate taxation.

Caution: Because an ILIT must be irrevocable, once you sign the trust agreement, you can’t change your mind; you can’t end the trust or change its terms.

Creating an ILIT

Your first step is to draft and execute an ILIT agreement. Because precise drafting is essential, you should hire an experienced attorney.  Although you’ll have to pay the attorney’s fee, the potential estate tax savings should more than outweigh this cost.

Naming the trustee

The trustee is the person who is responsible for administering the trust.  You should select the trustee carefully.  Neither you nor your spouse should act as trustee, as this might result in the life insurance proceeds being drawn back into your estate. Select someone who can understand the purpose of the trust, and who is willing and able to perform the trustee’s duties.  A professional trustee, such as a bank or trust company, may be a good choice.

Funding an ILIT

An ILIT can be funded in one of two ways:

1. Transfer an existing policy–You can transfer your existing policy to the trust, but be forewarned that under federal tax rules, you’ll have to wait three years for the ILIT to be effective.  This means that if you die within three years of the transfer, the proceeds will be subject to estate tax.  Your age and health should be considered when deciding whether to take this risk.
2. Buy a new policy–To avoid the three-year rule explained above, you can have the trustee, on behalf of the trust, buy a new policy on your life.  You can’t make this purchase yourself; you must transfer money to the trust and let the trustee pay the initial premium.  Then, as future annual premiums come due, you continue to make transfers to the trust, and the trustee continues to make the payments to the insurance company to keep the policy in force.

Gift tax consequences

Because an ILIT is irrevocable, any cash transfers you make to the trust are considered taxable gifts.  However, if the trust is created and administered appropriately, transfers of $12,000 or less per trust beneficiary will be free from federal gift tax under the annual gift tax exclusion.

Additionally, just as each of us has a lifetime estate tax exemption, we also have a lifetime gift tax exemption, so transfers that do not fall under the annual gift tax exclusion will be free from gift tax to the extent of your available exemption.  The gift tax exemption amount is $1 million.

Crummy withdrawal rights

Generally, a gift must be a present interest gift in order to qualify for the annual gift tax exclusion.  Gifts made to an irrevocable trust, like an ILIT, are usually considered gifts of future interests and do not qualify for the exclusion unless they fall within an exception.  One such exception is when the trust beneficiaries are given the right to demand, for a limited period of time, any amounts transferred to the trust.  This is referred to as Crummey withdrawal rights or powers.  To qualify your cash transfers to the ILIT for the annual gift tax exclusion, you must give the trust beneficiaries this right.

The trust beneficiaries must also be given actual written notice of their rights to withdraw whenever you transfer funds to the ILIT, and they must be given reasonable time to exercise their rights (30 to 60 days is typical).  It’s the duty of the trustee to provide notice to each beneficiary.  Of course, so as not to defeat the purpose of the trust, the trust beneficiaries should not actually exercise their Crummey withdrawal rights, but should let their rights lapse.

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