Corporations, other entities and the cash method of accounting have long been used to keep taxable income low; however, this has the potential to negatively affect future Social Security (SS) benefits.
Farmers approaching retirement often ask if it’s wise to report more income in the years before retirement in order to increase their SS benefits. The answer: It depends.
Benefits are based on the average of your 35 highest-earning years with each year indexed for inflation. The 2012 maximum wage base of $110,100 is almost equal to the indexed maximum 1983 wage base of $35,700.
Actual annual earnings are indexed based on that year’s factor, and then the highest 35 indexed years (40 quarters required) are determined and divided by 420 to arrive at your average monthly indexed earnings (AMIE).
Tier Teardown. AMIE is then allocated to three tiers. The first $791 of earnings are placed in Tier 1. Excess is placed into Tier 2, capping at $3,977. Any earnings above that amount are allocated to Tier 3. These tiers are critical in determining your benefits.
The first tier carries a 90% weighting. For example, if you have AMIE greater than the first tier, Tier 1 will count $712 toward your monthly benefits.
Earnings that fall into Tier 2 generate benefits equal to 32% of those indexed earnings. Even if you maximize Tier 2 (which is five times more than Tier 1), you only get an extra $560 of monthly benefits. Maximizing Tier 2 will generate SS benefits of $1,273.
Tier 3 has the least value. The monthly benefit generated by Tier 3 indexed earnings is 15%, up to $565 per month.
Assuming normal retirement age (67), the maximum benefit available is $2,550. If a farmer retires at 62, the benefits are reduced to about $1,912.
What’s the return on increasing income to get better benefits? First, let’s look at how many years it takes to recoup your Federal Insurance Contributions Act (FICA) investment for each tier. In the table below, we calculate the investment required to increase final monthly SS benefits by $100 and then determine the months needed to recoup your FICA investment.
Farmers should maximize any earnings that fall into Tier 1. The payback period for Tier 1 investments is less than five years. Tier 2 investments take about 14 years to recoup, while an investment to increase to Tier 3 takes at least 30 years.
Social Security Strategy. Healthy farmers should strive to maximize Tier 1. Once this investment is funded, the farmer must then make a judgment regarding how long he and his spouse will receive benefits. The longer the expectation, the more the farmer should invest to increase Tier 2. In most cases, a farmer would never invest to Tier 3.
What about spouses? Many spouses retire and receive SS benefits based upon one-half of the
primary beneficiary’s benefits. Therefore, any investment the farmer makes to Tier 1 will increase the benefit to the spouse by 50%, reducing the payback period on this investment by about a third.
Most healthy farm couples should maximize Tier 2 AMIE. Tier 3 should be avoided since both spouses will need to live to 90 just to break even.
For a spreadsheet to calculate your earnings and to see how it will impact your retirement benefits, e-mail me at paul.neiffer@CLAconnect.com.
Paul Neiffer is a tax accountant with CliftonLarsonAllen and author of the blog, The Farm CPA. He grew up on a wheat farm in Washington and owns a corn and soybean farm in Missouri. Contact him at paul.neiffer@CLAconnect.com.