Understanding the Social Security tax limit: Financial planning strategies

Social Security is a key component of retirement planning for many Americans. Recent reports highlight the perils facing the program. There’s currently only enough in the trust fund to guarantee 100% payments through 2033, per the Social Security Administration (SSA). Understandably, that’s concerning for many retirees or soon-to-be retirees. One proposal to save Social Security is to limit how much recipients can receive. The proposed six-figure limit (SFL) would cap the amount retirees can collect at $50,000 annually, or $100,000 for couples, according to the Committee for a Responsible Budget (CRFB). This is separate from the Social Security taxable wage base, as the SFL would limit exceedingly high annual benefits. If enacted, the SFL wouldn’t immediately affect most retirees, but it could affect higher-income households. If you fear the proposed SFL may catch you, strategies like purchasing annuities or dividend portfolios could help offset losses in benefits. Even if you’re not impacted, following these strategies can bring necessary diversity to retirement plans.

Financial planning strategies to diversify retirement income

Creating multiple income streams is beneficial for most retirees. Multiple income sources in retirement help to protect against market volatility and provide stability. Regardless of whether the proposed SFL becomes law, acting now will introduce greater flexibility into your retirement planning, which will be even more helpful if it does.

Selecting one or more of the following approaches can help diversify retirement income while addressing possible Social Security changes.

Annuity strategies for guaranteed income

Dependable income is prized by many retirees. Purchasing an annuity is a legitimate way for any retiree to replace income. An annuity is generally a contract between the purchaser and an insurance company. You deposit a lump sum or cash over time in exchange for payments.

There are five types of annuities you can purchase. Those are:

• Immediate annuities, where payments begin one year after purchase
• Deferred annuities, where payments start at a future date
• Fixed annuities that provide guaranteed payments for predictability
• Variable annuities that are somewhat tied to the market, offering possibly higher payments but more risk
• Indexed annuities that are tied to the market but include downside protection

Annuities can provide longevity protection, especially if you opt for a fixed annuity. Variable and indexed annuities offer more growth potential but also increase risk, not to mention complexity. Additionally, annuities may limit liquidity, and they can carry fees and surrender charges that can make them less than desirable.

Despite the drawbacks, for risk-averse soon-to-be retirees seeking a reliable income to supplement Social Security, annuities may be the solution.

Bond strategies and fixed income ladders

Purchasing bonds is another reputable way to augment income in retirement. A bond is a loan to governments or businesses that pays interest and returns principal upon maturity.

Government bonds are typically low risk, with terms ranging from several months to 30 years. Current bond rates are as high as 4.45%, according to Bloomberg.

Companies issue corporate bonds, which pay higher interest rates but carry higher risk.

Government bonds come in two forms:

• Treasury bonds, which the federal government issues, and interest is exempt from state and local taxes
• Municipal bonds, which local governments issue, generally give federal, state, and local tax exemptions

Unlike CDs, bonds are liquid, and you can sell them if you need cash. Pricing is inverse to interest rates. When interest rates rise, bond prices decline and vice versa.

Rather than purchasing a single bond or two, laddering them is a good way to manage needs in retirement. Laddering involves staggering maturity dates between one and ten years to manage interest rate risk. It also helps you achieve recurring income and relative liquidity.

Bond investments aren’t FDIC-insured, but laddering creates diversification and preserves capital.

CD ladders for conservative income generation

CD ladders can be another good way to create a stable income during retirement. Like bonds, CDs are generally suitable for risk-averse investors who don’t want to risk principal loss.

A key difference between bond and CD ladders is that CDs are FDIC-insured up to $250,000 per depositor, per institution. The FDIC coverage makes CDs attractive to conservative investors seeking predictable income.

The current best CD rates are up to 4-4.5%, and the return is guaranteed. Unlike bonds, CDs aren’t liquid, which is why laddering is beneficial. CDs traditionally range in maturity dates from several months to up to five years in most cases.

Let’s say you have $100,000 to invest in CDs. You would purchase five different CDs in equal amounts, like this:

• One-year CD = $20,000
• Two-year CD = $20,000
• Three-year CD = $20,000
• Four-year CD = $20,000
• Five-year CD = $20,000

As each CD matures, you can either take the cash for your needs, put it into another investment, or purchase another CD. CD ladders are best for investors who want liquidity at pre-determined intervals while also protecting their capital.

Dividend portfolios and income-focused investing

If you’re not averse to some level of risk, building a dividend portfolio is an effective way to bolster Social Security income. Although dividend stocks do expose you to the stock market, the income can be lucrative, depending on your strategy.

Chasing yield for yield’s sake isn’t always advisable, so considering blue-chip companies or dividend aristocrats is a measured approach to receiving dividends. Researching the firm’s history, payout ratios, and debt levels is advisable when purchasing dividend stocks.

Blue-chip companies are generally well-known businesses with long track records. Dividend aristocrats are members of the S&P 500 and have a history of increasing dividend payouts annually for at least 25 years. Both have the potential to create capital appreciation.

Dividend income is taxable, but it’s generally at a favorable rate. That rate is up to 20% rather than being taxed as ordinary income, according to Vanguard.

If you want to increase dividend payouts further, investing in real estate investment trusts (REITs) can be a good way to boost payouts and gain exposure to real estate. The tradeoff is that real estate is sensitive to interest rates, and you may not receive the same tax benefits as dividend stocks.

Creating a dividend portfolio requires due diligence to ensure it fits your appetite for risk. Speaking with a financial advisor is beneficial to construct the right portfolio for your needs. Selecting a diverse mix of stocks is a wise way to limit risk. For instance, an advisor may suggest a model portfolio like this:

• 50% dividend aristocrats
• 30% dividend growth stocks
• 20% REITs

Dividend portfolios expose you to market risk, but they also protect against inflation and offer possible capital appreciation.

Optimizing Social Security benefits regardless of cap changes

Having alternative streams of income doesn’t make Social Security irrelevant. Rather, the proposed SFL makes planning essential for higher-income households. Although the CRFB believes the SFL will initially affect only the top 0.05% of households, it’s wise to consider how potential limits may affect your situation.

Strategic claiming decisions

Traditionally, delaying the claiming of benefits as long as possible has been recommended by many financial experts to maximize Social Security benefits. After all, foregoing benefits past full retirement age (as old as 67 years old) adds 8% annually to benefits until you reach 70, according to the SSA.

Claiming as early as 62 years old means a reduction in benefits of up to 30%, per the SSA. Delaying benefits may still be advantageous for many soon-to-be retirees, but if you’re near the cap, you may need to be more purposeful in your planning.

Claiming benefits early will permanently reduce your monthly benefits and possibly lower your cap number. However, if you’re facing health concerns, job insecurity, limited savings, or more, it may be wise to claim when you can.

Waiting until 70 to claim Social Security undoubtedly has its benefits, but every situation is different. Running the numbers to determine the best time for you is prudent.

Spousal coordination strategies

If you’re married, claiming Social Security is best done holistically. Maximizing Social Security benefits will involve looking at it as a household decision. The SFL is constructed around a total cap for couples.

For households with two high-income earners, determine whether delaying creates enough value to justify it. Your total amount may be limited by the cap, so the payoff may not be there.

If only one partner is a high-income earner, it may be advisable for the other partner to claim benefits early. Doing so could increase the survivor benefit, which will be helpful if the high-income earner passes first.

Preparing for implementation: Next steps

The SFL is not yet a law. It’s merely a proposal, but with the looming insolvency, it may be wise to view this as a way to stress-test your retirement plans. It’s best to start by reviewing your latest Social Security statement to estimate projected benefits for both spouses. Then, compare that against the SFL proposal.

Depending on your circumstances, you will want to follow that up with other actions, including:

• Review your retirement accounts and determine your contribution limits
• Determine your income sources and identify gaps that additional strategies can fill
• Hire or meet with your financial advisor to create a plan

The first two will help identify exactly how to construct your portfolio.

It may be necessary to receive help from multiple individuals. A Certified Financial Planner (CFP) can be a good resource for retirement planning. You may also need a tax professional to ensure your planning is tax-efficient. Speaking with a Social Security representative may also be valuable for determining when it’s best to claim benefits.

Don’t view this as a one-and-done approach, either. Revisiting your situation at least semi-annually, or even quarterly, is a good way to optimize your plans.

Bottom line: Preparing your portfolio for Social Security policy changes

Lawmakers are debating how to fix Social Security to protect its solvency. The SFL proposal is not yet law, and if it becomes law, it will affect only a small number of recipients. That doesn’t mean it will stay that way, though. Regardless of where it lands, taking a thoughtful approach to Social Security’s role in the broader retirement planning process is vital. Whether or not the SFL becomes law or not is meaningless, on one hand. Retirees and soon-to-be retirees who build multiple income streams are better positioned to handle whatever policy changes or market shifts come their way in the future.