Putting a Social Security "Bonus" To Work
If you’ve reached the Social Security tax wage limit for 2019, or expect to before year-end, yours is an enviable problem indeed: how best to spend the extra dollars you get back in your paycheck.
Higher-income workers effectively get a raise each year once they hit the maximum earnings amount subject to Social Security taxation, at least until the new tax year begins on January 1. Like an unexpected raise or bonus, those extra dollars can help to fortify your financial position with minimal pain, but only if you put that money to work.
“I work primarily with physicians who generally all cross over that taxable wage base at some point during the year, so a lot of what I do is to educate them on how their paychecks get taxed and how to take advantage,” said Adam Claerbout, a wealth advisor and president of Physician’s Wealth Resource in Indianapolis, Indiana. “Most people have no idea, so my job is to say, ‘Hey, you’re going to get this Social Security ‘bonus’ halfway through the year and we need to plan for that.’”
The Social Security tax
Most employees pay 6.2 percent of their wages to help fund Social Security, the federal insurance program that provides benefits to eligible seniors, survivors, and the disabled. Their employers pay an additional 6.2 percent for a total of 12.4 percent. The self-employed pay the full 12.4 percent on their own.1
The Social Security payroll tax, along with a separate 1.45 percent (2.9 percent for the self-employed) tax for Medicare, is collected under the Federal Insurance Contributions Act (FICA). If your income exceeds $200,000 for individual filers, or $250,000 for married couples filing jointly, you must pay an additional 0.9 percent tax to Medicare.2
While the Medicare tax applies to all earned income, the Social Security Old-Age, Survivors, and Disability Insurance (OASDI) program puts a limit on the amount of earnings subject to taxation.
That limit jumped to $127,200 in 2017 from $118,500 in 2016 — an increase of $8,700 or 7.3 percent, reflecting the largest one-year increase since 1983, in part because federal law kept the taxable maximum unchanged for 2016.
Of the estimated 173 million workers who will pay Social Security taxes in 2017, the Society for Human Resource Management estimates roughly 12 million will pay more because of the increase in the taxable-maximum amount.3
An individual with wages equal to or larger than $127,200 will contribute $7,886.40 to the OASDI program in 2017, and his or her employer will contribute the same amount.4 The self-employed will pay double that amount.
Once that earnings limit is hit, however, their paychecks for the remainder of the year no longer withhold for OASDI tax, a roughly $657 per month savings.
Thus, depending on how much you earn and when you hit the limit, the extra dollars in your paycheck may amount to a sizeable sum.
“If your income is high, you may meet the Social Security wage limit in the first four or five months of the year,” said Denis Curcio, a financial advisor with Carroll Financial Associates in Charlotte, North Carolina, in an interview.
Many who meet the Social Security wage limit use their “bonus” to fund a vacation, pay for holiday gifts, or lighten their financial load. If your financial house is in order, said Curcio, that isn’t necessarily wrong. But before you fritter found money away, consider the following shrewd moves.
Save for a rainy day
“First, look at your short-term savings,” said Claerbout. “Do you have enough saved for an unexpected emergency?”
Most financial advisors recommend setting three to six months’ worth of living expenses aside in an interest-bearing account, but you may need to save up to a year’s worth of expenses if your job is unstable or your income is uncertain.
“If you are not addressing your short-term needs, you will eventually run into issues with your other financial goals,” said Claerbout.
Eliminate bad debt
Next, look to pay down high-interest debt, he said.
If you pay your balance on a credit card that charges 18 percent interest, that’s an immediate 18 percent return on investment.
According to nonprofit group American Consumer Credit Counseling, nearly half (49 percent) of U.S. consumers have household credit card debt of more than $10,000, and 35 percent have household credit card debt that exceeds $15,000.5
Credit card debt not only reduces your disposable income, but the interest charges you pay perpetuate a cycle of debt. By making the minimum monthly payments on a $3,000 credit card balance with a 18 percent annual percentage rate, for example, it would take you 132 months to pay off and cost an additional $2,497 in total interest charges, according to the Minimum Payment Calculator on CreditCards.com.
Max out your 401(k)
If you’re not already maxing out your 401(k) retirement plan, Claerbout said that’s the next best place to park your Social Security bonus.
Contributions to your 401(k) retirement plan are made on a pretax basis, which helps you lower your taxable income in the year you contribute. Earnings on the retirement account also grow tax deferred, delivering the potential for compounded growth, a key force behind wealth accumulation.
A 25-year-old with a $40,000 starting salary and nothing saved in his or her 401(k), would accumulate nearly $1.6 million by age 65 if he or she contributed 10 percent of his or her salary to a retirement plan each year, due largely to the magic of compounded growth, according to the AARP 401(k) calculator. The projection assumes a 7 percent annual rate of return, an annual 3 percent raise, and a 50 percent employer match on contributions up to 6 percent of his or her salary.
Most high-income workers should be able to contribute the maximum of $18,000 to their 401(k) plan every year, Claerbout said, but if they are not, they should at least contribute enough to claim the employer match. “You need to contribute at least enough to get the free money your employer is giving you,” he said.
Protect your family
If your emergency fund is stocked, your debt is under control, and your retirement savings are on track, Claerbout said he then recommends applying extra income toward ensuring your life insurance and disability income coverage is sufficient to protect your family.
“You need to ensure you have the right amount of disability insurance and life insurance,” he said. “These are financial priorities that apply to everyone, not just those getting a Social Security bonus.”
How much life insurance coverage you need depends on a variety of factors, including your age, income, debt (mortgage, student loans), assets (retirement savings, personal investments), and projected future expenses (college tuition). Childcare costs, and whether your spouse is earning an income or able to resume his or her career in the event of your passing, should also be considered. (Related: Life insurance calculator)
Disability income insurance, on the other hand, is designed to replace a portion of your income, including bonuses and commissions, if you become injured or too ill to work for an extended period of time. Many employers offer such insurance, but it may not be enough to cover your basic living expenses, if needed.
Ultimately, said Claerbout, the goal is to provide enough financial protection to help your family cover its current and future expenses if your paycheck suddenly stopped.
To determine an appropriate amount of coverage, it helps to speak with a financial professional. If your coverage is lacking, said Claerbout, consider applying any extra income toward purchasing more.
Fund your health savings account
Finally, said Curcio, those who funnel extra income into a health savings account (HSA), if available through their employer, not only get a triple tax advantage, but also an opportunity to bolster their retirement nest egg.
HSAs are medical savings accounts that are typically paired with high-deductible health insurance plans. Contributions are tax deductible and withdrawals that are used to pay for qualified out-of-pocket medical expenses, including vision and dental, are tax free.
Account owners can generally invest their HSA contributions in a variety of securities, including stocks, bonds, and mutual funds, to generate potential returns. Any gains earned in their account at year-end can continue to grow tax deferred. And the unused money in the account is not forfeited annually, as it would be in a flexible spending account.
HSAs can be used to pay for out-of-pocket medical expenses today and in retirement, including Medicare premiums and certain long-term care costs.
With the out-of-pocket cost of health care in retirement estimated to be $275,000 for a couple retiring this year with Medicare coverage, any extra HSA money you accumulate can come in handy. That figure does not include any expenses incurred for long-term care.
“If you are healthy, and have the resources, we recommend paying out-of-pocket for everyday health care expenses today and leaving your HSA contributions to accumulate tax-deferred earnings for use in retirement,” said Curcio. “Someone in their mid-40s or early 50s can put an extra $3,000 per year into their HSA and it could generate between $50,000 and $75,000 through compounded growth for use in retirement.”
In the end, regardless of what you decide to do with the money, it's all about self-discipline. If you reach the Social Security tax wage limit before year-end, and get to enjoy a fatter paycheck for a few months, don’t just waste it away.
“Most people just spend their Social Security bonus, especially if it kicks in towards the end of the year, right around the holidays,” said Curcio. “It goes right out the door to purchase gifts.”
The better plan is to use that extra income to pay down debt, protect your family, or boost your savings.
Shelly Gigante specializes in personal finance issues. Her work has appeared in a variety of publications and news websites. This article originally appeared on the MassMutual Blog.
1 Social Security Administration, “Benefits Planner: Maximum Taxable Earnings (1937 – 2017),” 2017.
2 Social Security Administration, “Fact Sheet: Social Security,” 2017.
3 Society for Human Resources Management, “2017 Payroll Taxes Will Hit Higher Incomes,” 2016.
4 Social Security Administration, “Contribution and Benefit Base,” 2017.
5 American Consumer Credit Counseling, “New Survey: Almost Half of Consumers Have Household Credit Debt Over $10,000,” 2017.