Income Tax on Social Security Benefits

Welcome

©2013, College for Financial Planning, all rights reserved.

Expectations of Students

• Commitment of time and energy

• Read the assignments

prior

to class

• This course will help you: o pass the CFP ® Certification Examination o better serve your clients/ grow your business o be successful on the

College’s end-ofcourse examination

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Professor contact information

Lobby & Welcome e-mail

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CERTIFIED FINANCIAL PLANNER CERTIFICATION

PROFESSIONAL EDUCATION PROGRAM

Retirement Planning & Employee Benefits

Module 1

Planning for Retirement &

Social Security


Learning Objectives

LO 1–1 leads you to examine our changing demographics and acknowledge the importance of lifestyle in retirement planning.

LO 1–2 involves knowledge of the process of retirement planning, from establishing goals with the client and gathering data, to analyzing the data and recommending a retirement savings program, to implementing and monitoring the program. This includes identification of general characteristics of vehicles for implementing a savings program in a tax-favored manner. These characteristics include the tax deferral available through a qualified plan or TSA, through capital gains treatment, and the benefits available for investment in a personal residence.

LOs 1–3 and LO 1–4 require you to demonstrate the ability to perform basic time value of money calculations on the financial function calculator and requires you to be able to take a given client situation and determine the retirement savings need. This process requires sorting through data to select the relevant information for the calculation.

LOs 1–5, 1–6, and 1–7 require you to learn the basic provisions of the various OASDI programs: old age (retirement), survivor, and disability benefits. Familiarity with these basic social insurance provisions enables the financial planner to assist clients in understanding the benefits that may be available to them. Taxation of Social Security benefits is also covered.

LO 1–8 covers the basics of Medicare, including eligibility and gaps in coverage.

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Video

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• 5:00 minutes

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Video Layout

Text chat or other questions

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Questions to Get Us Warmed Up

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The Changing Face of Retirement

• Increased longevity and reduced morbidity

• Implications of changing demographics o Extended retirement period to fund o Health care costs o Long-term care

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Retirement Needs Calculation

42% guessed how much they need to accumulate

21% asked a financial advisor

21% did their own estimate

9% read or heard how much is needed

7% used an online calculator

5% filled out a worksheet or form

5% based an estimate on current expenses or their desired retirement lifestyle

Source: Employee Benefit Research Institute and Mathew Greenwald & Associates, Inc., 2011

Retirement Confidence Survey. Note, some employees answered in the affirmative to multiple categories.

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Retirement Planning Process

Establish and define relationship

Gather data

Analyze the data, including determining the savings need for retirement

Develop and recommend a savings program

Implement the program

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Potential Retirement Assets

Fully taxable

• Savings

• CDs

• Investments

• Nonqualified deferred compensation

Tax favored

• IRA

• SIMPLE IRA

• SEP

• SARSEP

• 403(b) (TSA) plans

• 457 plans

Partially tax favored

• Annuities

• Life insurance

• Roth IRA

• Social Security and Medicare

• Nondeductible IRA

• After-tax qualified plan contributions

Qualified plans

• Defined benefit plans

• Defined contribution pension plans

• Defined contribution profit sharing plans

• SIMPLE 401(k)

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Replacement Ratios

• Replacement ratios

decrease

as income increases.

• Example of wage replacement ratio: salary of

$60,000

($6,000) minus 10% savings

($4,590) minus 7.65% share of payroll taxes

$49,410 wage replacement ratio of 82.35%

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Saving for Retirement

Three main calculations you need to know –

1.

How to calculate the lump sum needed at the beginning of retirement in order to fund the retirement period

2.

How to calculate the level savings amount needed to reach the lump sum amount

3.

How to calculate the serial payment amount needed

(increases each year for inflation) to reach the lump sum amount

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Determining Required Savings

1.

Offset annual need with Social Security and pension plan benefit, if appropriate.

2.

Adjust annual retirement income need for inflation.

3.

Calculate capital needed on day one of retirement as goal.

4.

Calculate the required savings to accumulate needed capital by day one of retirement.

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Inflation-Adjusted Yield

Reflects two percentage rates:

• the inflationary growth rate of income to be generated by the fund

• the investment return rate

Formula:









1



Investment

1



Inflation return









1





100

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Retirement Funding Example

George and Nancy wish to retire when George attains age 65. He is 46 this year. They estimate they will need $36,000 in today’s dollars in addition to Social Security. They want to assume an after-tax rate of return of 10% and inflation of 3%. They have no savings at this time, and they want the income until George is

95.

a.

What level payment will they need to deposit every year to reach their goal?

b.

What is the required inflation-adjusted

(serial) deposit one year from today?

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Lump Sum Calculation (10BII)

Clear and check calculator for 1 pmt/yr.

1.

Today $  Day one of retirement $

PV = 36,000, N=19, i =3, FV = $63,126

2.

The $63,126 now becomes a payment, which will increase each year with inflation to maintain buying power (begin mode).

pmt = 63,126, i = inflation adjusted 6.7961,

N = 30,

PV = $853,994

The lump sum of $853,994 will fund the 30-year retirement period.

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The Level Funding Calculation (10BII)

Clear and check calculator for 1 pmt/yr and

“END” mode.

1.

FV = 853,994, i = 10%, N = 19

2.

Therefore, PMT = $16,693

Inflation is already reflected in the $853,994, so only the expected return of 10% is used for “i” in this calculation.

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Serial Funding Calculation (10BII+)

Clear and check calculator for 1 pmt/yr, end mode.

1.

Deflate (because inflation will be taken into account with the serial payment):

Today $  Day one of retirement

FV = 853,994, N = 19, i = 3, then PV = 487,021

2.

Find payment: FV = 487,021, N = 19, i = 6.7961, then PMT = 13,304 .

3.

Inflate by 3% to reach the end of first year payment: $13,304 x 1.03 = $13,703 .

(End of second year payment would be

$13,703 x 1.03 = $14,114.)

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Level and Serial Compared

• First year level payment is $16,693.

• First year serial payment is $13,703.

• Serial payments will start out lower, but over time the serial payment will become higher than the level payment.

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Key Dates in History of Social Security

1935: Social Security Act signed into law

January 31,

1940:

First monthly payment

1940:

Dependents benefits & survivor benefits

1955: COLAs when enacted by Congress

1956:

Age 62 retirement for women

1957, amended 1960: Disability benefits

1961:

Age 62 retirement for men

1972: Medicare & Supplemental

Security Income (SSI)

1975:

Automatic COLA adjustments

1984: Social

Security Reforms

2006:

Medicare prescription drug program

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Groups Excluded from Social Security

• Federal employees hired prior to 1984

• Railroad employees covered under Railroad Retirement

System

• Business owners receiving only distributive income

(dividends) for services performed

• Children under age 18 employed by a parent in an unincorporated business

• State and local government groups covered by a retirement system where employer has elected to exclude Social Security coverage

• Employees of religious organizations opting out for religious reasons

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Income Subject to Social Security (FICA) Tax

• Wages, salary, tips, etc.

• Sick pay during first six months

• Employer-paid group term life premiums on any coverage above a $50,000 death benefit

• Employee salary reduction amounts to 401(k) 403(b), and 457 plans

• Nonqualified deferred comp deferrals when no longer subject to substantial risk of forfeiture (i.e., when it belongs to the employee and subject to income tax)

• Vacation or severance pay

• Nonqualified stock options

(upon exercise)

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Income Exempt From Social Security (FICA) Tax

• Sick pay after first six months

• Employer paid term life premiums on any coverage up to a $50,000 death benefit

• Payments from employer plan for medical or hospital expenses

• Pretax deferrals to a Flexible Spending Account (FSA)

• Employer contributions to qualified plans

• Nonqualified deferred compensation deferrals subject to substantial risk of forfeiture

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FICA Tax Rates

2013 FICA Taxable Wage Base

Compensation below wage base

OASDI tax

Health Insurance tax (HI)

Total

Compensation above wage base

Health Insurance tax

$113,700

Employee Employer

6.2%

1.45%

6.2%

1.45%

Total

12.4%

2.9%

7.65% 7.65% 15.3%

Employee Employer Total

1.45% 1.45% 2.9%

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OASDI

Old Age, Survivors, and

Disability Insurance has three main components:

1.

Retirement

(old age)

2.

Disability

(disability of wage earner)

3.

Survivorship

(death of wage earner)

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Key Terms in OASDI Programs

• Quarter of coverage ($1,160 in 2013)

• Currently insured/Fully insured

• Average Indexed Monthly Earnings (AIME)

• Full retirement age (FRA)

• Primary Insurance Amount (PIA)

• Spousal benefit

• Benefit reductions due to age

• Benefit reductions due to earnings

• Events that trigger the end of benefits

• Divorced spouse coverage (married 10 years)

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Full Retirement Age

Born

Before 1938

1938-1942

1943-1954

1955-1959

After 1960

Full Retirement Age

65

65 plus monthly adjustment

66

66 plus monthly adjustment

67

Age 62 Benefit

80%

75-80%

75%

70-75%

70%

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Benefit Adjustments Due to Age

• Benefit is based on PIA at full retirement age (FRA)

• Persons beginning benefits prior to FRA will have benefits permanently reduced.

o By 5/9 of 1% per month for the first 36 months.

o Plus an additional reduction of

5/12 of 1% per month over the remaining months.

• Persons beginning benefits after

FRA, but under age 70, will receive an increased monthly benefit.

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Benefit Reductions Due to Earnings

Age

62 to year of FRA

After reaching FRA

You will lose

$1 in benefits for every

$2 of earnings above

Amount (2013)

$15,120

No benefit reduction

$40,080

Unlimited

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Retirement Earnings Test Example

Item

Total Social Security benefits

(75% of maximum FRA amount)

Earnings

Social Security earnings limit (2012)

Excess earnings

Reduction in Social Security benefits

(50% of excess earnings)

Net Social Security benefits

Amount

$19,665

$41,080

$14,640

$26,440

$13,220

$ 6,445

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Social Security Disability Benefits

• Social Security pays benefits to people who cannot work because they have a medical condition that is expected to last at least one year or result in death.

• Disability payments begin after a five month waiting period

• Individuals on Social

Security disability automatically qualify for Medicare after 24-month waiting period.

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Qualifying for Social Security Disability Benefits

1.

Disabled worker must be fully insured (at least 40 quarters) and

2.

Have worked for at least 20 of the last 40 quarters

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Qualifying for Social Security Survivor Benefits

1.

Deceased worker must have been either fully insured

(40 quarters) or

2.

Currently insured

(at least 6 of last 13 quarters)

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Social Security Benefit Review

Benefits will be paid to: Retirement

Worker, Under FRA Reduced* PIA

Worker, FRA & Over

Disability

100% of PIA

100% of PIA Disability benefits cease; retirement benefits begin

Spouse, age 60 or 61 No benefit No benefit

Spouse, age 62 to FRA

Spouse, FRA or older

Spouse, any age, caring for child under age 16 or disabled

Unmarried child under age 18 (19 if in high school) or any age if disabled

50% of PIA, reduced

50% of PIA

50% of PIA

50% of PIA

(subject to family maximum)

Death

N/A

N/A

100% of PIA, reduced

100% of PIA, reduced

100% of PIA

75% of PIA, reduced

(worker was currently insured)

75% of PIA, reduced

(worker was currently insured)

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Johnson Family Example

• Robert Johnson died at age 35. Survivors are: o Wife, Jane (age 35).

o Daughter, Juli (age 6).

o Son, Bobby (age 3).

• His PIA is $1,200.

• Maximum family benefit is $2,250.

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Family Limits

Juli’s Benefit, 75% of

PIA Reduced to $750

Bobby’s Benefit, 75% of

PIA Reduced to $750

$1,200 PIA X 75% = $900

$900

$900

$2,700

$2,250 family max.

$450 reduction

Jane’s Benefit, 75% of

PIA, Reduced to $750

Widow(er)’s Blackout Period*

Jane’s SS =

71.5% † PIA

35 40 45 47 48 50 55

Jane’s Age

60 65 66

*If widow(er) is disabled within seven years of spouse’s death. Social Security payments may begin at age 50.

† If benefits begin at 60. 71.5% PIA; at 62.75% PIA: at 65, 100% PIA.

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Income Tax on Social Security Benefits

Threshold income: joint filers

Less than $32,000

Threshold income: single filers

Less than $25,000

$32,000 to $44,000 $25,000 to $34,000

Greater than $44,000 Greater than $34,000

Percent of Social Security retirement benefit subject to income tax

None

Up to 50%

Up to 85%

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Income Tax on Social Security Benefits

Thresholds are arrived at by using “provisional income.” The main components of provisional income are:

• AGI

• Tax-exempt interest income (muni bonds)

• One-half of OASDI benefits

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Medicare Part A Provisions

Coverage

Age 65 and eligible for

Social Security OR

After entitlement to disability benefits for 24 months

Benefits

Hospitalization

Skilled nursing care

Gaps

Deductible

Co-payment

Home health care Costs beyond benefits provided

(extended hospital stays)

Hospice

Blood

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Medicare Part B Provisions

Eligibility Benefits

All persons eligible for Part A Medical Expenses:

Home health care

Hospital outpatient

Blood

Physician services

U.S. resident citizens over age 65 paying minimums

Coinsurance

Gaps

Deductibles

Inpatient and outpatient medical services & supplies

Costs greater than Medicareapproved charges

Physical and speech therapy Routine physicals

Ambulance Eyeglasses, hearing aids, dental care, custodial care

Vaccines

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Medicare Part D: Prescription Drugs

Deductible - $325

Coverage - $2,645

Donut Hole - $3,763.75

Total

Individual

$ 325.00

Medicare Total

$ 0 $ 325.00

$ 661.25 $ 1,983.75 $ 2,645.00

$ 3,763.75 $ 0 $ 3,763.75

$ 4,750.00 $ 1,983.75 $ 6,733.75

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Gaps in Medicare

• Deductible for Part A ($1,184 per incident for inpatient hospital care)

• Deductible for Part B ($147 annual)

• Cost of extended hospitalization under Part A (tiered system, full cost after 150 days)

• Coinsurance of 20% for Part B

• Cost for drugs not paid for under Part D (deductible, coinsurance, and donut hole)

• Custodial care nursing home costs

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Practice Problem 1

The Smiths, both age 40, have analyzed their current living expenses and estimated their retirement income need, net of expected Social Security benefits, to be $22,000 in today’s dollars. They are confident that they can earn a 6% after-tax return on their investments, and they expect inflation to average 4% over the long term.

They want to plan for a 30-year retirement period beginning at age 65.

Determine the lump-sum amount the

Smiths will need at the beginning of retirement to fund their retirement income needs.

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Bill and Mary Parker are projected to need a lump-sum retirement fund of $4,353,036 in 25 years. Their assets will amount to $4 million on the first day of the retirement year, leaving $353,036 to be saved over the pre-retirement period.

Assuming an inflation rate of

4% and an after-tax return of

6%, calculate the Parkers’ annual serial (increasing) savings requirement.

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The Simpsons need to save an additional

$300,000 (in retirement year 1 dollars) to build a sufficient retirement fund to support their targeted retirement lifestyle.

They expect to earn a 7% after-tax return on their retirement savings and want to assume a 5% long-term inflation rate.

Their preference is to allocate a level annual savings amount to build this fund.

What level annual savings amount will the Simpsons need to deposit at the end of each year during their

20-year preretirement period?

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CERTIFIED FINANCIAL PLANNER CERTIFICATION

PROFESSIONAL EDUCATION PROGRAM

Retirement Planning & Employee Benefits

Module 1

End of Slides


Income Tax on Social Security Benefits

Welcome

Expectations of Students

prior

Housekeeping Items

Learning Objectives

Video

Questions to Get Us Warmed Up

Learning Objectives

The Changing Face of Retirement

Retirement Needs Calculation

Retirement Planning Process

Potential Retirement Assets

Replacement Ratios

decrease

Learning Objectives

Saving for Retirement

Determining Required Savings

Inflation-Adjusted Yield

Retirement Funding Example

Lump Sum Calculation (10BII)

The Level Funding Calculation (10BII)

Serial Funding Calculation (10BII+)

Level and Serial Compared

Learning Objectives

Key Dates in History of Social Security

Groups Excluded from Social Security

FICA Tax Rates

OASDI

Key Terms in OASDI Programs

Full Retirement Age

Benefit Adjustments Due to Age

Benefit Reductions Due to Earnings

Retirement Earnings Test Example

Social Security Disability Benefits

Social Security Benefit Review

Johnson Family Example

Family Limits