US Social Security and the Detrimental Effect of WEP
Most Brits are barely cognisant of the UK state pension system (no judgement – it’s complicated) and then they move to America and have to wrap their heads around an even more complicated – also generous – system in Social Security.
But it is important to know if you qualify and how much income you can expect to receive 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 aims to address the basics of social security but it’s not an exhaustive explanation. It is relevant for British expats living in the US and potentially expats from other countries as well. There are many details outside the scope of this blog as well as situations that will not be addressed. The hope is that you come away with a high-level understanding of social security and you know where to find more information.
There are 3 components to the US social security program: retirement, disability benefits, and survivors’ benefits. Additionally, your qualification for Medicare depends on your social security earnings. This blog will focus on the retirement income program including the effect of the Windfall Elimination Provision (WEP). A subsequent blog will address Medicare.
Both of these are relevant and important topics for our clients and are very poorly understood.
Here is a high-level summary of social security retirement income:
- Similar to the 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).
- 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 based on the age you start receiving it, 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.
- In general, to qualify for retirement benefits as well as Medicare, – – 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 2023, the maximum amount of income subject to social security taxes is $160,200. 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%.
- You also pay a 1.45% Medicare tax (and your employer pays 1.45% also) on all your earnings (i.e. no ceiling), plus an Additional Medicare Tax of 0.9% on earning over $250k for those filing as “Married filing Jointly”. If you are self-employed, you are responsible for paying the total 2.9%.
Primary Insurance Amount (PIA)
Your final income entitlement is based on your Primary Insurance Amount (PIA). Without getting lost in the details, here’s an overview:
- PIA is based on your Average Indexed Monthly Earnings (AIME)
- AIME is based on the 35 years with your highest income; the SSA then looks at your monthly income for 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 complicate things right now).
- This average monthly income (subject to the cap) is then split into three parts and you receive a percentage of each in retirement (in 2023, this is: 90% on first $1,115, 32% on amounts $1,116 to $6,721 and 15% on amounts $6,722 to $13,350).
More About Retirement Income
- The lowest income earners receive the most income 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. $147,000 in 2022; $118,500 in 2015; $90,000 in 2005 etc.) – will have built up a maximum entitlement. For someone retiring in 2023 at FRA, their maximum benefit would be around $3,627 p.m. ($43,524 p.a. p.a.).
- For someone who delays starting benefits until age 70, in 2023 the maximum benefit would be $4,555 p.m. ($54,660 p.a.). For someone starting benefits in 2023 at 62, the earliest age possible, the maximum benefit would be $2,572 p.m. ($30,864 p.a.).
- More on this later, but working and non-working spouses also qualify for up to 50% of this, meaning, in 2023 terms, at FRA a married couple could “earn” up to $65,286 p.a. inflation linked income based on one spouse’s full contribution record.
- The vast majority of our clients earn over the maximum amount. and as such can expect to max out their contributions each year. The question is, how many years will they get in before retiring?
- Remember, you get nothing unless you have 10 years (40 credits) under your belt – 9 years maximum contributions = nada).
- We strongly encourage you set up your social security account online where you can view all your info and run projections.
- If you wish to delve deeper, here are 32, admittedly very helpful, pages published by the Social Security Administration (SSA).
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. You can claim whichever is higher, which is a nice touch, but not both.
Current spouses are eligible for spousal benefits. 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 benefits does not affect the amount the “primary” spouse may receive.
Once you and your spouse start receiving Social Security benefits, upon the death of your spouse, you will continue to receive the higher of your benefit, or your spouse’s.
There is more information on this here.
Taking Early or Delaying
If you start your social security income 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). You’ll get an extra 2/3 of 1% for each month you delay after your birthday month, adding up to 8% for each full year you wait until 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. 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 (including 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 ($21,240 in 2023) 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 ($56,520 for 2023). 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
Whether your social security income is taxable depends on your total income for that year. If you’re married and file a joint return, 85% of your social security benefit will be taxable if your combined income is over $44,000 ($34,000 if you file as single).
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 citizen or a permanent resident of the United States (Green Card holder), you are subject to US 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, 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 hopefully 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 reduction to someone’s SS retirement benefits because they receive a pension that was funded by employment earnings that were not subject to US Social Security taxes. This applies to someone who paid National Insurance Contributions (NICs) and is eligible to receive the UK State Pension.
The good news is that the WEP reduction will not apply if you have been paying into Social Security for 30 years (i.e. your contribution record is 30 years or more).
If you have a contribution record of more than 10 years (minimum to qualify) and less than 20, your SS retirement benefits will be reduced by the maximum amount – $557.50 p.m. ($6,690 p.a.). in 2023 OR 50% of the amount of the non-covered pension, whichever is LOWER).
If your contribution is between 20 and 30 years at your retirement date, then there is a sliding scale for how much you will be penalized.
If you want to understand the calculation and prescribed formula better, please visit here.
Here’s another resource from the Social Security Administration.
Estimating your WEP Exposure
The SSA has an online calculator to help you estimate the reduction in your social security as a result of WEP.
If you are interested in reducing your WEP penalty, then consider continuing to work and make SS contributions for the full 30 years (or as close as you can get).
Beware of the Exchange (FX) Rate
The Social Security Administration (SSA) determines and fixes your UK SP in dollar terms at the time you first declare it to them on Form SSA-308. Your UK SP is paid in GBP, but you declare it in USD terms at the prevailing FX rate at that time.
Here’s the rub – someone with £5,000 p.a. UK SP in 2008 at GBP:USD of $2 is deemed to have a much higher income that someone declaring £5,000 p.a. UK SP in 2023 at GBP:USD of $1.2. We’re talking $10,000 p.a. Vs $6,000.
As a result, because it is calculated in at the beginning, continuing the above example, the poor guy (or gal) who started their UK SP in 2008 could be being penalized up to $5,000 p.a. Vs the 2018 retiree suffering only a maximum penalty of $3,000 p.a.
However, we have heard that it is possible for Social Security recipients to request that their WEP penalty be recalculated when/if the FX rate changes.
Bottom line, because you can only be penalized a maximum of 50% of the UK SP income, you are always best to take both SS retirement benefits and UK SP assuming you are entitled to them. Just be mindful that if you start your UK SP at a time when GBP is strong against the dollar, you could end up effectively being penalized more than 50% because GBP has weakened (or USD strengthened, or both) and yet you are still getting paid your UK SP in GBP and getting a whole lot less for it when you bring it into the US.
Future of US Social Security and UK Pensions
If you’ve ever reviewed your formal 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 for example).
But let’s be realistic about this, there is no alternative; we must 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!
Need Help with the Windfall Elimination Provision?
Plan First Wealth is here to help you navigate social security. See how we can use our Cross Border Expertise to help other British expats in America.
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