As you near retirement age, there are planning ideas and rules for stock compensation that you should know about.
You have been paying Social Security taxes for your entire working life, including those on the income you recognized from the exercise of nonqualified stock options (NQSOs) or the vesting of restricted stock/RSUs. As you near retirement age, there are planning ideas and rules for stock compensation that you should know about as you make decisions on Social Security benefits. This article provides the core knowledge to inform those decisions.
The later you take your Social Security benefits, the larger your payment will be.
When to Start Taking Social Security Benefits
There is no simple answer to the question of when you should take benefits, whether:
- early, at age 62
- at the age you are considered at "full retirement" as defined by Social Security rules (e.g. 66 years old for those born between 1943 and 1954)
- at a later time, up to age 70
The later you take your benefits, the larger your payment will be (check your Social Security statement with your personal benefits estimate from the Social Security Administration). Your benefits increase about 8% per year while you delay taking them, up to the age of 70. Then your payment remains level before any inflation adjustments.
According to the way the actuarial calculations work, if you live to your full life expectancy, you will receive the same total amount whether you take benefits early, at full retirement, or later. When you get it later, your checks are just bigger but you get fewer of them (unless you live longer).
Whatever the case, the right decision about when to start collecting Social Security ultimately depends on how long you live. The website SocialSecuritySolutions.com has a tool that can help you determine when to start taking benefits.
How Stock Compensation Affects Your Decisions
When you have good health, a sizeable portfolio, and other income sources (e.g. shares from option exercises, restricted stock vesting, or ESPP purchases), one strategy is to delay the start of Social Security benefits until you are 70 if that income gives you enough cash to wait. This approach can also give you a larger cash-flow safety net if your investments, including your company stock holdings, drop in value and you need more money later in life for other needs. Even if you die before reaching 70, your eligible spouse's survivor benefits will be larger than they would be if you had started taking benefits earlier.
Example: You retire early when you turn 62. You then start to exercise any outstanding stock options and sell the shares, along with others you own, until you reach the age of 70. The proceeds from these sales of company stock (and from any earlier sale proceeds you have saved) approximately equal what you would have received from Social Security had you elected to receive benefits at age 62. When you are 70, you start to receive Social Security benefits. The benefit-payment amount is much higher than it would have been if you had claimed Social Security benefits earlier.
Income from equity compensation and company shares can let you delay the start of Social Security benefits until you are 70 if the income gives you enough cash to wait.
Annual Earnings Limit of Social Security
When you start receiving Social Security before you reach the full retirement age, your benefits are reduced by a complicated formula for income above the annual limit. Income from the exercise of employee stock options is not investment income that is exempt from the annual earnings limit: it is compensation income. But assuming you received the options before retirement and the income is attributable to services rendered prior to retirement, it should not have an impact on the excess earnings test. Similar reasoning probably applies to restricted stock that vests after retirement. See Special Payments After Retirement at the website of the Social Security Administration (SSA).
The source of any post-retirement income in Box 1 of your W-2 may be unclear to the Social Security Administration (SSA), leading the SSA to mistakenly put your income above the annual limit. For NQSO exercises, the requirement to show NQSO income separately in Box 12 of the W-2 with Code V should clarify the source of the income in Box 1 of the W-2.
Age When Earnings Test Eliminated
In addition, The Senior Citizens' Freedom to Work Act of 2000 eliminated the Social Security annual earnings test in and after the month in which you reach full retirement age (FRA). The FRA was age 65 in 2000 through 2002. Starting in 2003, it began to increase annually and will do so until it reaches 67 for people born in 1960 or later. Earnings at or after FRA do not count toward the earnings test. Only earnings before the month of FRA count toward the earnings test and reduce your benefit.
Social Security Tax Continues
You pay Social Security and Medicare taxes on all wage and self-employment earnings, regardless of your age. Even for stock grants from a prior employer, the company will probably withhold these taxes depending on which exercise strategies the company offers and therefore, what you elect. However, these taxes do not apply to ISO exercises (same as before retirement).
The good news is that if your extra earnings are substantial, they may increase your monthly benefit payment. The retirement benefit is based on average earnings over a set number of years. According to the Social Security Administration, a benefit is increased only if the earnings in or after the year of retirement are higher than the earnings of earlier years for which they may be substituted.
Taxation of Your Benefits
If you continue to have substantial earned income after you begin taking Social Security payments, or income from other sources (e.g. investments), you will probably have to pay income tax on most of these benefit payments under a complicated formula. In general, according to the three-tiered income thresholds the IRS uses for modified adjusted gross income, upper-income retirees (income over $44,000 for married joint filers or over $34,000 for single filers) will need to include 85% of their Social Security benefit in their taxable income.
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Morgan Stanley Smith Barney LLC (“Morgan Stanley”), its affiliates and Morgan Stanley Financial Advisors or Private Wealth Advisors do not provide tax or legal advice. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for legal matters.
This material has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
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