Where can a 70-year-old buy the least expensive life annuity?

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This article was first posted on September 1, 2007. Updated May 28, 2008.

August 24, 2010 Breaking News
-- Social Security proposed rule may end Withdrawal of Application strategy, see link.

December 08, 2010 Breaking News
-- The Social Security Administration issued new rules today that end
the Withdrawal of Application strategy, effective immediately., see link.

Surprisingly, it's probably your local Social Security Administration office.

Many savvy investors are reluctant to do business with commercial insurers. From high fees and commissions to class action lawsuits for unethical sales practices to multi-million dollar fines for outright fraud like this one for The Hartford, it's prudent to approach these financial services firms with a good deal of suspicion. Indeed, a recent paper by Wharton School Professor David F. Babbel, Rational Decumulation noted the difficulty that retirees have in finding an "actuarially fair" annuity. Even with improvements over the past decade, commercial insurers still generally charge 2% to 5% more than the mortality table would indicate. The markup (in the form of the annual expense ratio) on the kind of low-cost index fund that many retirees hold would be a small fraction of that (0.10% to 0.20%.)

On the other hand, Mitchell, Poterba, Warshawsky, and Brown (1999) find that annuities offered in 1995 were reasonably priced and that the transaction costs of purchasing an annuity have declined rapidly. In particular, they found that the expected present values of fixed nominal annuities reflected a markup in the range of 6% - 10%, when evaluated relative to the mortality tables of those who actually purchase annuities. Yet we find that today, eleven years later, the markups on nominal annuities have dropped to about half those levels and that fixed real annuities reflect a markup of only 2%. Orszag (2000) emphasizes that for consumers whose preferences fit Yaari’s original assumptions, annuities are affordable because any transaction costs are more than compensated by the higher rate of return. [Babbel, D.F., Merrill, C.B., Rational Decumulation, July 2006, Page 6]

A little-known Social Security provision effectively allows you to "purchase" a life annuity from the Social Security administration at a substantial discount to what a commercial insurer would charge for the same monthly benefit. Delaying taking Social Security benefits until age 70 gives a retiree a monthly check as much as 77% larger than a retiree who started taking benefits at age 62. But you don't have to delay taking benefits until age 70 to take advantage of this. The Social Security Administration allows you to "withdraw your application" for benefits, reapply at a later date, and get the same larger monthly check as someone who delayed taking Social Security until that age. Of course, you'll have to pay back all the Social Security benefits you've received to date, but you won't have to pay back interest on the money and you'll be eligible for either a tax deduction or tax credit on the income taxes you paid on the Social Security benefits collected to date. If you save and invest the Social Security benefits you collect from age 62 to age 69 and then reapply at age 70 for the larger monthly benefit, you'll likely have tens of thousands of dollars in after-tax earnings beyond the amount that you repay to the Social Security Administration. The table below illustrates this result for a 62-year-old who retired in 2000 with the maximum benefit. It's interesting to note that "buying" an annuity from the Social Security Administration costs 36% less than purchasing the same benefit from Vanguard.

Take Social Security Benefits From Age 62 to Age 69, then refile at age 70
Social Security Benefits								-----	Save & Invest the SS Benefits
Year	Age	COLA	Monthly Benefit	Annual Benefit	Amount of SS Benefit subject to tax 85.00%	Tax Paid at 25.00% tax rate	After tax Amount Invested	-----	Jan 01 Bal	After-tax Deposit	Earnings @ 5.00%	Tax on Earnings @ 25.00%	Dec 31 Bal
2000	62	2.40%	$1,248	$14,976	$12,730	$3,182	$11,794	-----	$0	$11,794	$442	-$111	$12,125
2001	63	3.50%	$1,292	$15,500	$13,175	$3,294	$12,206	-----	$12,125	$12,206	$1,064	-$266	$25,130
2002	64	2.60%	$1,325	$15,903	$13,518	$3,379	$12,524	-----	$25,130	$12,524	$1,726	-$432	$38,948
2003	65	1.40%	$1,344	$16,126	$13,707	$3,427	$12,699	-----	$38,948	$12,699	$2,424	-$606	$53,465
2004	66	2.10%	$1,372	$16,464	$13,995	$3,499	$12,966	-----	$53,465	$12,966	$3,159	-$790	$68,800
2005	67	2.70%	$1,409	$16,909	$14,373	$3,593	$13,316	-----	$68,800	$13,316	$3,939	-$985	$85,070
2006	68	4.10%	$1,467	$17,602	$14,962	$3,740	$13,862	-----	$85,070	$13,862	$4,773	-$1,193	$102,512
2007	69	3.30%	$1,515	$18,183	$15,456	$3,864	$14,319	-----	$102,512	$14,319	$5,663	-$1,416	$121,078
Total SS benefits				$131,664	.	.	.	-----	Total Earnings		$23,191	.	.
Taxable portion				x 0.85	.	.	.	-----	Tax @ 25%		-$5,798	.	.
Taxable SS				$111,914	.	.	.	-----	After-Tax Total		$17,393	.	.
assume 25% tax rate				x 0.25	.	.	.	-----	.		.	.	.
Tax credit to line 70c of Form 1040				$27,979	.	.	.	-----	.		.	.	.
Net Cost of Withdrawal of Social Security Application ($131,664 - $27,979) =				$103,685	.	.	.	-----	.		.	.	.
.
Monthly Social Security Benefit @ Age 70				$2,515	.	.	.	-----	.		.	.	.
Increase in Monthly SS Benefit ($2,514 - $1,515) =				$999	.	.	.	-----	.		.	.	.
.
Cost of Vanguard inflation-adjusted life annuity @ age 70 with a $999/month benefit =				$167,161	.	.	.	-----	.		.	.	.
.
Savings: Soc. Security Withdrawal vs. Vanguard annuity ($167,161 - $103,685) =				$63,467	.	.	.	-----	.		.	.	.

If you want to run your own numbers, you can download a copy of the Excel spreadsheet, click here. (file size= 27 KB)

Federal income tax treatment of life annuity benefits

The taxation of the monthly annuity benefit from a commercial insurer depends on the source of the funds used to buy the annuity. If you use "non-qualified assets" (i.e., after-tax money) to buy the annuity, then approximately 30% of the monthly annuity benefit to a 70-year-old is exempt from income tax since it's regarded as a "return of capital". If you use "qualified assets" (e.g., the money in your IRA or 401k account which hasn't been taxed yet), then 100% of the monthly benefit is taxed when you withdraw it from your IRA.

By contrast, only 85% of your monthly Social security benefit is subject to Federal income tax. This is true even though the tax credit you get on the money you reimburse to the Treasury as part of the Withdrawal of Application effectively allows you to make the purchase with pre-tax money.

How come I've never heard of anyone doing this "Withdrawal of Application" Social Security scheme?

The Social Security Administration reports that only about 100,000 Form SSA-521s were filed in 2006. That's lost in the round off given the 48 million Americans who drew Social Security benefits during that year. Even if you personally knew 500 Social Security recipients, the odds are that only one of them has done a Withdrawal of Application.

Most of the Withdrawal of Application forms are filed by retirees age 62 to age 66 who have earned more than $12,960 limit on wage and salary income for 2007. Above that threshold, retirees lose $1 in Social Security benefits for every $2 they earn until they reach their normal retirement age. If your earnings are enough to trigger the penalty, it makes sense to suspend your Social Security benefit.

The number of retirees who file a withdrawal of application in their late 60's is limited to those with sufficient cash on hand to pay back the Social Security benefits earned to date. As the table above illustrates, that could be well over $100,000 for a retiree who started benefits at age 62 and collected anywhere near the maximum Social Security benefit.

Request and approval process for a Withdrawal of Application

You can download a copy of Form SSA-521 Request for Withdrawal of Application from the SSA website. When completing the form, make sure you give a reason for withdrawing your application such as "it makes financial sense for me to increase my monthly Social Security benefit by withdrawing my application and refiling at age 70 rather than buying a life annuity from an insurance company." Then take the form to your local Social Security office. They can confirm the exact amount of the Social Security benefits you've received to date and you can write a check for that amount and attach it to the application. You should be given a receipt for the reimburement.

There is an approval process for a Withdrawal of Application, but it's mostly geared towards preventing a Social Security recipient who is suffering from dementia or confusion from doing something that's not in their financial interest. Other than that, these requests are routinely approved. The Social Security Policy Manual details the request and approval process for a Withdrawal of Application.

What about the monthly Medicare premium that is deducted from my Social Security check?

If you're like most Social Security recipients and have your Medicare premium deducted from your monthly benefit check, you'll need to make other arrangements to pay the premium for the several month period between filing the Withdrawal of Application and restarting your Social Security benefits. Call 1-800-MEDICARE for the options for paying your Medicare premium directly.

How much will my Social Security benefit increase from age 62 to age 70?

The Social Security Administration publishes a handy table that answers this question. For someone born in 1924, the increase from age 62 to age 70 is only 44%. Those born in the years 1943-1954 see a 76% increase. Those born in 1962 or later see a 77% increase. The exact amount of the increase depends on whether you've have any wage and salary income after age 62 that increased your Primary Insurance Amount (PIA)

What to conclude from this provision of Social Security?

Given the ability to withdraw your Social Security application and then refile at a later date, about the only reason I can think of for delaying taking Social Security benefits beyond age 62 is if you continue to work and earn more than the annual limit causing your benefits to be penalized. Most of the articles extolling the advantages of delaying taking Social Security until age 70 like this recent column by Scott Burns (MSN Money: Hold off collecting Social Security) seem to ignore the fact that "you can have your cake and eat it, too" by pursuing the withdrawal of application option. If you delay taking Social Security until age 70, you could come down with an illness in the interim that significantly shortens your lifespan. In that case delaying benefits would have been a mistake. If you start taking benefits at age 62, you can always reevaluate your health status at age 69 and do a withdrawal of application and refile if you're still in good health and "feeling lucky."

Additional Information on Requests for Withdrawal of Application and the taxation of Social Security benefits.

Withdrawal of a Social Security application

From the Social Security Handbook

http://www.ssa.gov/OP_Home/handbook/handbook.15/handbook-1515.html

1515. Right to Withdraw Application

1515.1 Can you withdraw your application?

Yes. You may withdraw your application if:

You (or a person acting on your behalf) files a written request for withdrawal before we make a decision on your application; and

You are alive at the time the request is filed.

If we approve your request to withdraw an application, the application will be considered as if it was never filed. If we deny your request for withdrawal, the application is treated as if the request for withdrawal was never filed.

Note: There is no right to reconsideration or appeal based on a withdrawn claim. You must file a new application if you later wish to claim benefits.

1515.2 Can you withdraw your application after SSA makes a decision on your claim?

You may withdraw your application after we make a decision on your claim if the conditions in the above section are met and if:

All individuals whose entitlement would be voided by the withdrawal agree, in writing, to the withdrawal; and

The person who requested withdrawal repays any benefits received based upon entitlement on the claim that is voided by the withdrawal.

Even if you withdraw a claim, we keep your application form and all related papers.

1515.3 Can an application be withdrawn after a claimant dies?

After the claimant's death, an application may be withdrawn, regardless of whether we have made a decision on it if:

The application was for retirement benefits that would be reduced because of the claimant's age;

The claimant died before we certified his or her benefit entitlement to the Treasury Department for payment;

A written request for withdrawal is filed by or for the person eligible for widow(er)'s benefits based on the claimant's earnings; and

The conditions in (A) and (B) of the above section are met.

1515.4 What is the effective date of withdrawal?

Ordinarily, the filing date of the withdrawal is the day we receive the request and the filing date is used to determine if withdrawal is requested before or after a determination is made on the application. The withdrawal, however, does not become effective until SSA approves the withdrawal request.

1515.5 Can you cancel a request to withdraw an application?

You may cancel a request to withdraw an application if you file a written request at a proper place (see §1505), and the claimant is alive at the time you file the request for cancellation. For a cancellation request received after we approved the withdrawal, you must file the request no later than 60 days after the date of the notice of approval.

(To withdraw from medical insurance after a period of entitlement, see Chapter 24.)

Last Revised: Aug. 1, 2006

Retire Early or Late Social Security Benefit Calculator
http://www.ssa.gov/OACT/quickcalc/early_late.html#late

Taxation of Social Security Benefits

For married couples with modified Adjusted Gross Incomes over $44,000 per year(and everyone else with an income over $34,000 per year) 85% of your Social Security benefit is subject to ordinary income taxes. This short article from the IRS website, Are Your Social Security Benefits Taxable? and IRS Publication 915 can give you the details.

Tax treatment of repayment of Social Security Benefits

When you withdraw your application and repay the Social Security benefits paid to you to date, the Internal Revenue Service allows taxpayers to take either an itemized deduction or tax credit for any income taxes they paid on the Social Security benefits they received.

From IRS Publication 915 - Social Security and Equivalent Railroad Retirement Benefits

http://www.irs.gov/publications/p915/ar02.html#d0e3874

Repayments More Than Gross Benefits

In some situations, your Form SSA-1099 or Form RRB-1099 will show that the total benefits you repaid (box 4) are more than the gross benefits (box 3) you received. If this occurred, your net benefits in box 5 will be a negative figure (a figure in parentheses) and none of your benefits will be taxable. Do not use Worksheet 1 in this case. If you receive more than one form, a negative figure in box 5 of one form is used to offset a positive figure in box 5 of another form for that same year.

If you have any questions about this negative figure, contact your local SSA office or your local RRB field office.

Joint return. If you and your spouse file a joint return, and your Form SSA-1099 or RRB-1099 has a negative figure in box 5, but your spouse's does not, subtract the amount in box 5 of your form from the amount in box 5 of your spouse's form. You do this to get your net benefits when figuring if your combined benefits are taxable.

Example.

John and Mary file a joint return for 2006. John received Form SSA-1099 showing $3,000 in box 5. Mary also received Form SSA-1099 and the amount in box 5 was ($500). John and Mary will use $2,500 ($3,000 minus $500) as the amount of their net benefits when figuring if any of their combined benefits are taxable.

Repayment of benefits received in an earlier year. If the total amount shown in box 5 of all of your Forms SSA-1099 and RRB-1099 is a negative figure, you can take an itemized deduction for the part of this negative figure that represents benefits you included in gross income in an earlier year.

Deduction $3,000 or less. If this deduction is $3,000 or less, it is subject to the 2%-of-adjusted-gross-income limit that applies to certain miscellaneous itemized deductions. Claim it on Schedule A (Form 1040), line 22.

Deduction more than $3,000. If this deduction is more than $3,000, you should figure your tax two ways:

Figure your tax for 2006 with the itemized deduction included on Schedule A, line 27.

Figure your tax for 2006 in the following steps:

Figure the tax without the itemized deduction included on Schedule A, line 27.

For each year after 1983 for which part of the negative figure represents a repayment of benefits, refigure your taxable benefits as if your total benefits for the year were reduced by that part of the negative figure. Then refigure the tax for that year.

Subtract the total of the refigured tax amounts in (b) from the total of your actual tax amounts.

Subtract the result in (c) from the result in (a).

Compare the tax figured in methods (1) and (2). Your tax for 2006 is the smaller of the two amounts. If method (1) results in less tax, take the itemized deduction on Schedule A (Form 1040), line 27. If method (2) results in less tax, claim a credit for the amount from step 2(c) above on Form 1040, line 70, and write “I.R.C. 1341” in the margin to the left of line 70. If both methods produce the same tax, deduct the repayment on Schedule A (Form 1040), line 27.

Links for additional information

Financial Advisor Magazine - Little known rule lets you restart Social Security 02/29/2008
http://www.fa-mag.com/news.php?idNews=1296&id_content=4

www.analyzenow.com -- Ask Bud Hebeler when to take Social Security Benefits? 01/04/2004
http://www.analyzenow.com/Ask%20Bud/Ask%20Bud%20Response/Ask_Bud_when_to_start_social_security_11_3_06.htm

Andrew Tobias column of 04/11/2006
http://www.andrewtobias.com/newcolumns/060411.html

Vanguard Group - Social Security: Does it pay to delay? 07/23/2007
http://www.vanguard.com/VGApp/hnw/VanguardViewsArticle?ArticleJSP=/freshness/News_and_Views/news_ALL_socialsecurity_07232007_ALL.jsp&SYND=RSS&Channel=AN

Morningstar Conversation #55481 -- The "risk" of waiting to take Social Security 12/18/2006
http://socialize.morningstar.com/NewSocialize/asp/FullConv.asp?forumId=F100000015&convId=189849&minReplySeq=1#replyTop

Morningstar Conversation #45213 -- OT When to take Social Security? 11/14/2005
http://socialize.morningstar.com/NewSocialize/asp/FullConv.asp?forumId=F100000015&convId=159663&minReplySeq=1#replyTop

Morningstar Conversation #32377 -- When to take Social Security Benefits? 01/04/2004
http://socialize.morningstar.com/NewSocialize/asp/FullConv.asp?forumId=F100000015&lastConvSeq=32377

Charles Schwab -- When should you take Social Security? 02/21/2007
http://www.schwab.com/public/schwab/research_strategies/market_insight/retirement_strategies/planning/when_should_you_take_social_security.html?refid=P-1880644&refpid=P-1880905

CS Monitor -- When does it pay to take Social Security benefits early? 06/04/2007
http://www.csmonitor.com/2007/0604/p13s01-wmgn.html?page=1

CNN Money -- When taking Social Security benefits early is a mistake 06/06/2007
http://money.cnn.com/2007/06/06/pf/retirement/social_security_early/index.htm