Select talks with an expert about what the retirement earnings test is and how it works.

When it comes to planning for retirement, choosing the right time to collect your Social Security benefits can have a significant impact on how much you end up earning in benefits over the course of retirement. Despite Social Security benefits comprising a large portion of people's retirement income, many of those close to retirement age don't know basic facts about the program. 

A 2020 study done by MassMutual found that nearly 52% of people failed or barely passed a survey of 12 questions regarding Social Security. The study tested people on everything from what full retirement age is to their knowledge of when the Social Security trust fund would be drawn down.

While misconceptions about how the program works are common, not knowing the basics of Social Security could lead people to lose out on benefits. The earnings test is one aspect of Social Security retirement benefits that is commonly misunderstood. The earnings test applies to people who are earning income and collect benefits before full retirement age.

Below, Select talks to an expert about what the earnings test is and how it works.

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Let's start by reviewing some basics about Social Security. 

The Social Security administration uses a formula based on a worker's income in their 35 highest earning years (indexed for inflation) to calculate their benefits. Everyone is eligible to collect worker benefits starting at age 62, although full retirement age (FRA) is between age 66 and 67, depending on when you were born. However, if you collect before FRA, your monthly benefit will be permanently reduced by a certain percentage for every month before FRA that you choose to collect.

Individuals who wait until age 70 to collect are able to earn an additional 8% in benefits for every year after the full retirement age. This means an individual with a full retirement age of 67 can earn 124% of their monthly benefit if they wait until age 70.

For example, if their monthly benefit was $3,000 at FRA but they waited until age 70 to collect, they would instead receive $3,720 per month.

The retirement earnings test was a feature of the first Social Security legislation passed by President Franklin Roosevelt during the Great Depression in 1935. 

The Social Security earnings test applies to people who are earning an income [i.e. a salary from job] and choose to collect benefits before FRA. For every dollar an individual makes above a certain income limit, the Social Security administration will withhold some of their benefits.

In other words, a working individual, who collects before FRA, will receive a reduced percentage of their benefits.

However, it's important to remember that those withheld benefits are not lost forever. Workers will recoup those lost benefits once they hit FRA. This means that the benefits that the Social Security administration withheld from workers before FRA will be fully paid out to them later on.

Though the earnings test has undergone many legislative changes since 1935, it still remains in place. 

While it's commonly thought that the test was first passed to encourage older workers to leave the workforce in order to make room for younger workers during the Great Depression, historian Larry Dewitt writes in 1999 that "the RET is part of the Social Security Act for the basic reason that Social Security was designed as an insurance scheme, which seeks to compensate covered individuals who suffer a loss of income due to retirement."

Retirees may be reluctant to work while collecting benefits because of the retirement earnings test, but in reality, it shouldn't have any impact on whether you choose to work or not.

(Note: If you make enough income, Social Security could end up withholding all of your benefits, so you might be better off waiting to collect if you're not receiving any of your benefits before FRA.)

Furthermore, if you keep on working, the Social Security administration considers those earnings on your work record and may recalculate a higher benefit for the succeeding years.

According to Jim Blair, Lead Consultant at Premier Social Security, the Social Security administration will calculate how much of your benefits are withheld, based on the income limit, and then send you fewer checks or a lower monthly benefit.

After you reach FRA, the Social Security administration will recalculate the value of your benefit so you're not cumulatively losing any benefits.

To summarize, you may not receive your full Social Security payments if you're still working, once you hit FRA, you'll receive any of that money that was previously withheld. This could be in the form of extra checks or a higher monthly benefit.

There are two different income limits for the earning test: there's a lower limit for the retirees who are more than one year away from FRA and a higher limit for people who are one year or less from FRA. Income is considered wages from an employer and does NOT include investment earnings, government benefits, interest or capital gains.

In 2022, the lower limit was $19,560. So for every $2 an individual earns above this amount, the Social Security administration will withhold $1 from a worker's benefit. The higher limit is $51,960. For every $3, you earn above this amount, the Social Security administration will withhold $1 from your benefit. This means that the year an individual turns 67, they can earn up to $51,960 before the earnings test kicks in (i.e. before the government would withhold benefits if you were still working).

Consider this example:

The Social Security administration provides a Retirement Earnings Test calculator on their website.

Lastly, the earnings test impacts the spousal benefit too. If either you or your spouse is working while collecting the worker or spousal benefits before FRA, both of your benefits may be withheld. In other words, the worker's salary will influence the worker's benefit AND the spousal benefit while the spouse's salary will just impact the spousal benefit. 

Social Security is intended to supplement people's other sources of retirement income, whether that's from 401(k)s, traditional and Roth IRAs or pensions. The average Social Security monthly benefit is only $1,658, hardly enough money for retirees to live off of in retirement, so it's crucial that individuals save for retirement as early as possible.

Your first priority should be maxing out your employer's 401(k) match as it's essentially free money. After you've maximized your match, you might consider opening a traditional or Roth IRA, depending on which account you're eligible for.

A Roth IRA offers people a unique tax advantage: Your initial contributions are taxed so your investments grow tax-free over time. However, there's an income limit on Roth IRAs. For individuals, your income must be below $144,000 and for married couples filing jointly, their income must be below $204,000. A Roth IRA is a good option for people who think they'll be in a higher income tax bracket in retirement.

On the other hand, a traditional IRA offers a different type of tax advantage. Your upfront contributions are not taxed, so you pay taxes on your distributions in retirement. There is no income limit for a traditional IRA.

Depending on your income and whether your employer offers a retirement plan, your traditional IRA contributions may be tax deductible. This means that your contributions reduce your taxable income which reduces the amount of money you owe in taxes in the year you contribute.

Select ranked Charles Schwab, Fidelity Investments, Vanguard, Betterment and E*TRADE as offering the best IRAs.

The decision of when to collect your Social Security benefits can have a dramatic impact on your finances in retirement. If you don't know what your FRA is, how the earnings test works or how the spousal benefit works, you could be missing out on thousands of dollars in benefits.

With the earnings test, the Social Security administration withholds some portion of your benefits if you're still working and decide to collect benefits before your FRA. However, it's important to remember that these benefits are not lost forever and that you'll receive the withheld money once you hit FRA, either in the form of a higher monthly benefit or more checks.

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Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.

Rashik Parmar