Using economic magic to pull retirement money out of a hat

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Larry Kotlikoff’s Social Security original 34 “secrets”, his additional secrets, his Social Security “mistakes” and his Social Security gotchas have prompted so many of you to write in that we now feature “Ask Larry” every Monday. Find a complete list of his columns here. We are determined to continue it until the queries stop or we run through the particular problems of all 78 million Baby Boomers, whichever comes first. Let us know your Social Security questions. Kotlikoff’s state-of-the-art retirement software is available here, for free, in its “basic” version.

Before answering a few Social Security questions, I’m going to perform an awesome economic magic trick. Specifically, I’m going to pull money — a large amount of money — out of a hat. I’m also going to tell you how the trick works, how you can perform it at home, and convince you it’s real.

I’ll need a subject. Ah, here’s one — my hypothetical friend Steve. Steve, who never married, lives in Delaware with his five cats, affectionately named One, Two, Three, Four and Five.

Steve just turned 62 and has a planning horizon of age 100. Yes, Steve knows the chances are small he’ll live to 100. But he also knows he just might and doesn’t want to risk running out of money if he lives that long.

Steve has $300,000 in regular assets, $300,000 in a standard 401(k) and $300,000 in a Roth IRA. Steve’s plan is to immediately start taking his Social Security age-62 benefit of $1,704 and also begin smoothly withdrawing his retirement account holdings.

“Smooth withdrawal” means taking the same amount (adjusted for inflation) from his retirement accounts each year between now and age 100.

Steve’s also decided to withdraw his Roth money first. Taking out the Roth money won’t trigger higher federal and state income taxes because he paid taxes on his Roth contributions when he made them. But withdrawing his 401(k) money will trigger higher taxes because contributions to his 401(k) were made tax free. (More precisely, they were excluded from his adjusted gross income.) By taking his Roth money out first, Steve figures he’ll defer paying taxes on his 401(k) withdrawals and earn some extra interest during the deferral.

I ran Steve through my company’s free online financial planning program, called ESPlannerBASIC. It shows Steve can spend $48,945 in today’s dollars (after inflation) straight through to age 100.

Now for the magic.

Drum roll as my hands return to the keyboard.

Next, I try having Steve take his Social Security benefit starting at age 70. I also have him take his 401(k) money out first and Roth money out second.

Changing these inputs in ESPlannerBASIC takes me about 4.342 seconds. Rerunning the program takes another 0.621 seconds.

Now Steve’s sustainable spending is $56,581. That’s a 15.6 percent increase in Steve’s spending for the rest of his life. And it takes less than five seconds!

Based on Steve’s original plan (taking Social Security at 62 and the Roth money first), he’d need an extra $250,000 in non-retirement account assets to attain this higher living standard.

So I’ve just pulled $250,000 out of a hat.

What’s the trick?

A big part is having Steve wait until 70 to collect Social Security. Doing so means his benefit, when it starts, will be 76 percent higher in real terms (adjusted for inflation). Yes, this will mean giving up eight years of benefits, but Steve will get the 76 percent bump to his monthly Social Security check for 30 years. And, again, Steve must plan to live that long because, as Dr. Seuss wrote, “If it could be, it would be.”

The other, smaller part is having Steve take his 401(k) benefit first and his Roth money second. Taking the Roth money first, not second, produces lower real sustainable spending, namely $55,974.

The fact that Steve can spend more each year by taking his Roth money second means he’s saving taxes over his lifetime. Yes, Steve’s giving up the deferral advantage. But ESPlannerBASIC has our incredibly complex tax system programmed in all its gory detail. And one of these details, a truly nasty one, is that up to 85 percent of our Social Security benefits can become taxable depending on their size, the amount of our other taxable income and the year.

Why the year? Because the thresholds beyond which the first 50 percent and then 85 percent of our Social Security benefits are taxable aren’t indexed for inflation. So every year after Steve starts taking Social Security entails a potentially higher degree of Social Security benefit taxation.

By taking his Roth money second, Steve reduces the size of his other taxable income because, recall, Roth withdrawals aren’t taxable and aren’t considered part of taxable income (adjusted gross income, to be precise). In Steve’s case, limiting the extent of Social Security benefit taxation beats tax deferral as a lifetime tax-saving device.

ESPlannerBASIC was ranked the number one planning tool on the web by Money Magazine. It has a highly sophisticated (and patented) mathematical algorithm under its hood. Yes, it’s a black box. But you can easily verify from its reports that it’s making the right calculations.

There is no other program like it. And no human being (including myself, and I designed it, building on decades of other other economists’ and mathematicians’ work in personal finance and numerical computation methods) can make these calculations in his or her head.

There’s no login required and no ads to distract you. It’s a free money machine brought to you by one of nature’s greatest gifts — economics. Use it!

Joseph Dever — Philadelphia: I lost my job when I was 62. My unemployment ran out. And I was still paying a mortgage. So, I started collecting Social Security, and did so for two years. My question is: Is your ex notified when you start collecting on their Social Security? I am 66 and back at work. Trying to get some cash in the 401K plan.


Pose Your Questions to Larry Here

Larry Kotlikoff: No, your ex is not necessarily notified, but if the ex asks for the information from the Social Security Administration, he or she is entitled to know to whom and how much is being paid from his or her account. However, information about the ex’s whereabouts cannot be disclosed.

Also, one of the requirements to be entitled to divorced spousal benefits is that the ex-spouse on whose account benefits will be paid must be at least age 62. Unless proof of age has previously been established, the ex-spouse may need to be contacted to obtain the necessary documentation.

Mike Robertson — Memphis, Tenn.: My mother and father were married 27 years; they have been divorced the same amount of time. My father is remarried; my mother is not. Can she collect his Social Security benefits before he is deceased? He received twice as much as her and she has no other income. If she must wait until he is deceased to collect, will she receive his entire benefit? Both of them are over 75. Thank you!

Larry Kotlikoff: Your mother is no doubt collecting her own retirement benefit. If she hasn’t yet filed for a divorced spouse’s spousal benefit, she should do so right away. It will be calculated as an excess spousal benefit (the difference between half of your father’s full retirement benefit and 100 percent of your mother’s full retirement benefit), but this could very well be small or zero. Once your dad passes away, your mom can collect a divorced spouse’s widow’s benefit. This could equal 100 percent of what you dad is now receiving.

Norma — Delhi, La.: I married my ex in January 1972. We divorced in June 1981, remarried each other in November 1983 and divorced again in May 1993. We were married to each other a total of just under 20 years. He is 64 and still working. I am 62 and am on SSI and have never remarried. Am I eligible to collect on his Social Security earnings?

Larry Kotlikoff: Gee, I think not because you weren’t married for 10 consecutive years in either case. Social Security restarts the 10-year marriage clock required for divorced spouses to collect when they remarry, including when they remarry their former spouse. I hate delivering this news because I think this is incredibly unfair.

Kris Cloyd — Shrewsbury, Mass. If a wife starts collecting her Social Security benefits at age 62, she would collect 75 percent of her full retirement benefit. If her spouse dies and is eligible for survivor benefits, would she collect 100 percent or 75 percent of his full retirement benefit?

Larry Kotlikoff: As described in this column, if the decedent spouse took retirement benefits earlier than his full retirement age, depending on when the widow collects, the survivor benefit may be less than the decedent husband’s full retirement benefit, equal to or greater than the benefit he was receiving, or 82.5 percent of the husband’s full retirement benefit.

Susan Nininger — Chapel Hill, N.C.: I was a homemaker for 15 years and during that time I had assorted part-time jobs. Then I worked at a mall starting as a receptionist, and after seven years, I was the operations manager and often acting property manager. Three years ago, I was forced out. The best salary I made was $55,000.00 for two years. I am still unemployed and my savings are depleted. If I collect my Social Security at 64, I get around $800 per month. My ex is a physician and should have a good Social Security income. He is older than 62. If I am unable to find work, should I file against his benefit at 64 and then go to mine at 66? Or start with his? Any ideas?

Larry Kotlikoff: If you were married for 10 or more years you can collect a full spousal benefit (equal to half of your ex’s full retirement benefit) starting no earlier than your full retirement age. Then you can wait until 70 to collect your highest possible retirement benefit, which may just exceed your full spousal benefit.

If you file at 64 for your spousal benefit, you’ll be forced to take your reduced retirement benefit early as well. But having filed for your retirement benefit, your reduced spousal benefit will no longer be your full spousal benefit, but your reduced excess spousal benefit, which may be very small or zero.

So, I think it’s probably best to wait until full retirement age and file just for a full spousal benefit and then wait until 70 to go for your own retirement benefit. First-rate Social Security software can show you the options.