Are you confused by US Social Security and UK Pensions?
I’m not sure how many US citizens really understand how their Social Security program works (not all that many, I suspect), but I am certain that very few British expats understand US Social Security and UK Pensions. But it is important to know just how much income you can expect to take from it in retirement – it’s much higher than our UK State Pension – and therefore, you should have at least a basic understanding of it.
This blog is aimed solely at our clients (and people like our clients). It is not an “explain all” – we are just trying to explain the relevant bits and discard the superfluous details and jargon . Some of it might not be relevant for you if you aren’t the kind of client PFW works with (successful British expats living in America).
This is not exhaustive and, if in doubt, I’ve erred on the side of caution (i.e. over-simplified rather than over-explained). It is meant to be read and understood in one sitting.
Social Security benefits include: Retirement Income, Disability Income, Medicare and Medicaid.
This blog will examine Retirement Income, another will look at Medicare and another still will deal with the Windfall Elimination Provision (WEP); these are the relevant/important topics for our clients and are very poorly understood.
Here are 28, admittedly helpful, pages from the Social Security Administration (SSA) themselves:
- Much like our UK State Pension, workers in the US build up an income entitlement via a tax on their wages that is paid jointly by employee and employer (up to a certain income limit – $142,800 in 2021)
- Full Retirement Age (FRA – please remember that acronym because it’s going to come up a lot) is 67 for those of us born after 1960. if you were born before 1960 then your FRA is likely to be between 66 and 67
- Retirement benefits may begin as early as age 62 at a discounted rate
- The amount you receive in retirement increases from age 62 through to age 70. You do not have to take benefits at age 70 years old, but there is no monetary benefit to waiting beyond that age
- To qualify for any benefits – retirement income, Medicare etc – you need 10 years’ worth of contributions (40 credits). This is very important, especially for expats who came to America later in their careers, because it you fall short of 40 credits you may have paid a significant amount into the pot and might not be eligible to get anything back out of it and, furthermore, you won’t qualify for Medicare. If you plan on retiring in the US, you probably don’t want to be without Medicare.
- In 2021, the maximum amount of income you pay social security taxes on is $142,800. This ceiling is increased, usually annually, and sometimes quite substantially
- You pay 6.2% up to this limit, as does your employer. If you’re self-employed you’re on the hook for the full 12.4%.
- Your final income entitlement is based on your Primary Insurance Amount (PIA), which I’m not going to get into, but at a super high level:
- PIA is based on your Average Indexed Monthly Earnings (AIME)
- AIME is based on the 35 years with your highest income; the SSA then works out what your monthly income was based on those 35 years (if you have less than 35 years of contributions, the no entry years get marked as $0, so it brings your average down).
- They literally just add up your income for those 35 years and divide by 420 (420 month = 35 years) et voilà, they have your average monthly earnings (inflation is accounted for, but let’s not complication things right now).
- This average monthly income (subject to the cap) is then split into three sections and you receive a percentage in retirement (in 2021, this is: 90% on first $996, 32% on $996 – $6,002 and 15% on $6,002 – $11,900)
- So, the lowest income earners receive the most as a percentage of their pre-retirement wage in Social Security Retirement benefit.
- Those who have maxed out – who have 35 years at or above the income limit for each year (e.g. $142,800 in 2021; $118,500 in 2015; $90,000 in 2005 etc.) – will have built up a maximum entitlement of $37,776 p.a. in 2021, if they take it at the FRA of 66 and 2 months (this is in today’s terms and will increase with inflation and is $46,740 p.a. for those who have deferred to age 70).
- More on this later, but non-working spouses also qualify for up to 50% of this, meaning, in 2021 terms, at FPA a married couple can “earn” up to $56,664 p.a. inflation linked income based on one spouse’s contribution record
- The vast majority of our clients earn over $142,800 p.a. and as such can expect to max out their contributions each year. The question is, how many years will they get in before retiring?
- For a married couple, with one spouse not working, this is essentially $1,619 p.a. inflation linked income entitlement for each year of maximum contributions (remembering you get nothing unless you have 10 years (40 credits) under your belt – 9 years maximum contributions = nada).
- So, if you earn above the cap and always have (bearing in mind it was lower in the past than it is now) and always will, and you expect to be working for a total of 20 years in the U.S., then, back of an envelope calculation, we can estimate that you’ll be eligible for c.$32,380 p.a. income (20 x $1,619) from social security, based on one working spouse and one homemaker/non-working spouse, in today’s terms when you reach your FRA.
- We strongly encourage you set up your social security account online where you can view all your info and run projections:
Current spouses have eligibility for spousal benefit. You must be age 62 to file for or receive a spousal benefit. You are not eligible to receive a spousal benefit until your spouse files for their own benefit first. Taking spousal benefit does not affect the amount the “primary” spouse may receive.
As a spouse, you can claim a Social Security benefit based on your own earnings record, or you can collect a spousal benefit that will provide you 50% of the amount of your spouse’s Social Security benefit as calculated at their FRA (67 if you were born after 1960). You can claim whichever is higher, which is a nice touch.
Once you and your spouse start receiving Social Security benefits, upon the death of your spouse, you will continue to receive your benefit, or your spouse’s (if higher), but not both.
Some more info on this here:
Taking early or delaying
Social Security FRA is 67. Benefits can start being drawn from age 62, at a reduced rate. Payments can be delayed to age 70 (or later, but there is no financial incentive to delay past 70).
If you start early, your benefit will be permanently reduced, by up to 25% (if you start as early as possible, which is age 62).
If you delay, your benefit will be permanently increased, by up to 32% (if you delay to age 70).
Essentially, it’s a gamble based on how long you live. There’s no right or wrong answer to what you should do, until we can see in the future, but in the meantime we can run different models at the relevant time to help you decide how to play this hand.
If you delay past 70 there are no further increases applied, so don’t delay past 70!
Working while taking benefits
Earning a wage (or even self-employment income) can reduce your benefit temporarily if you take Social Security early. If you’re still working and you haven’t reached your FRA, $1 in benefits will be deducted for every $2 you earn above the annual limit ($18,960 in 2021) if you are under FRA for the entire year. In the year you reach full retirement age, $1 in benefits will be deducted for every $3 you earn above a different limit ($50,520 for 2021). They only count your earnings up to the month before you reach your FRA, not your earnings for the entire year
Starting the month you reach your FRA, your benefits are no longer reduced no matter how much you earn.
Any reduction in benefits due to the earnings test is only temporary. You receive the money back in the form of a higher benefit at FRA, so don’t use the reduction as the sole reason to cut back on working or worrying about earning too much.
NOTE: As long as you’re working in a job that’s covered by Social Security, you’ll have to keep paying Social Security and Medicare taxes indefinitely, regardless of your age or benefit status
Taxation in Payment
Essentially, every client we work with is going to have to pay federal income tax on 85% of their Social Security retirement income.
Currently 13 states tax Social Security benefits: Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia.
Four of these states — Minnesota, North Dakota, Vermont, and West Virginia — use the same formula as the IRS to determine how much of your Social Security benefits might be subject to tax. The others have their own income thresholds, many of which are significantly more generous than those of the IRS
If you do not live in one of these 13 states then you will not pay state income tax on your social security benefits.
Retiring outside the US
For our clients – British expats – unless you move to North Korea or Cuba (not joking), you will be able to continue to collect your Social Security benefits, as will your surviving spouse, wherever you live and regardless of whether you are a US citizen or not. That is as long as both parties are UK citizens; it could get more complicated if one of you isn’t and you are a citizen of a country that does not have a Social Security Agreement with the US, as the UK and several other countries do.
Remember, if you are a U.S. citizen or a permanent resident of the United States (Green Card holder), you are subject to U.S. income tax laws no matter where you live. This means that your worldwide income, including up to 85% of the Social Security benefits you get, may be subject to federal income tax.
If you are not a US citizen, or you are not a permanent resident of the United States, Uncle Sam will withhold a 30% federal income tax from 85% of your benefit amount, unless you meet the conditions of an income tax treaty that reduces your tax rate. This withholding tax results in 25.5% withholding of your monthly benefit amount.
The United States has a treaty with the United Kingdom (and a handful of other countries) that eliminates this tax. If you retire elsewhere, you may have to wear it, but you will almost certainly be able to offset it against the income taxes in your country of residence. Also, do bear in mind that even if you can avoid this withholding tax, you are almost certainly still going to be liable for income tax on it in your country of residence.
For more information on this, check out this resource:
Windfall Elimination Provision (WEP)
WEP is a feature of Social Security that can lead to benefits being reduced to reflect a “eligibility for a pension from work not covered by Social Security” – i.e. the UK State Pension. So, if you have built up an entitlement to the UK State Pension you may find that your Social Security Retirement Benefits are reduced as a result.
Future of US Social Security and UK Pensions
If you’ve ever seen a physical Social Security statement you probably noticed the caveat that politely informs you that the Social Security Trust Fund is projected to be depleted by 2034. In short, this is due to changing demographics and the depleting number of workers per retiree (or, should I say, growing number of retirees per worker).
This does not mean that the program will finish because there are no funds left; the SSA will still be collecting billions annually in Social Security taxes. It does however mean there will be no surplus fund left to maintain payments at the current level promised. Essentially, “reform” is coming. And essentially, “reform” is a euphemism for “reduction” (or a delay I guess – FRA pushed back to 70 perhaps).
But let’s be realistic about this, there is no alternative; we just have be aware of it and plan for it. The consensus seems to be that benefits could be reduced by as much as 25%, so let’s just build that into you plan and say a little prayer each night thanking your lucky stars that you aren’t one of the estimated 33% who the SSA say depend on Social Security benefits for 90% of their retirement income!