Clients who worked in the public sector may be in for a rude surprise when they apply for Social Security benefits: their assumed benefits could be significantly less than anticipated.
If a client's earnings history includes income from payroll-tax paying private sector jobs, as well as a salary from public sector work, a perceived conflict may arise.
As a result, planners need to help their clients understand, anticipate and plan around these possible benefit surprises. Two provisions cover these situations: The Windfall Elimination Provision and the Government Pension Offset. The WEP applies when the worker is a public sector employee, the GPO when a spouse claiming spousal benefits is a public sector worker.
More than one million beneficiaries, including state or local government employees such as police, firefighter or administrative staff, are affected by the WEP, according to the Congressional Research Service. Almost 30% of public educators are not covered by Social Security.
CLARIFYING THE CONFUSION
Adding to the confusion, the statements provided by the Social Security Administration project future benefits but may not account for any reduction due to public sector earnings.
Public sector workers often do not pay Social Security payroll tax, since their employer provides their own retirement benefit or pension. This decreases lifetime Social Security taxed income with the effect of pushing a higher-wage earner with a lower replacement rate into a lower-wage earner income level, with a higher replacement producing a perceived windfall.
However, if a worker has always paid Social Security payroll tax on all earnings the WEP does not apply and there is no reduction in benefits.
WEP may reduce benefits if the worker had either of two types of public-sector retirement benefits: a pension or a lump-sum payment. Pensions are a more common option.
WILL BENEFITS BE REDUCED?
In general, Social Security benefits are based on average lifetime monthly earnings adjusted for inflation (AIME). AIME is multiplied by three replacement rates — 90%, 32% and 15% — to arrive at the actual monthly benefit.
The WEP reduces benefits by ratcheting the 90% factor down to as low as 40%. The amount that the 90% factor is reduced depends on the total number of years during which the worker had substantial Social Security taxable earnings.
If the worker had 30 years or more of substantial Social Security earnings, there is no WEP reduction to benefits.
But if there are less than 30 years of substantial earnings, the 90% factor is decreased by 5% for each year. For example, only 25 years of substantial earning would decrease the 90% factor to 65%. The lowest this adjustment can go is down to 40% when there are only 20 years of substantial earnings.
For example, a base benefit of $1730 would be reduced to $1302 if a worker only had 20 years of substantial earnings, or $1516 if they had 25 years.
The precise definition of substantial earnings is critical — and they are published annually by the SSA. They range from $900 in 1937, to $22,050 in 2016. Anything less than these amounts, and the year does not qualify as one with substantial earnings.
There are two important constraints on WEP reductions. First, there is an absolute maximum reduction depending upon years of substantial earnings. The maximum reductions for 2016 range from $428 per month (for 20 years substantial earnings), to $43 per month (29 years). No matter what actual value is generated by calculations, benefits will never be reduced more than these amounts.
The reduction is also limited for workers with smaller pensions. Their WEP reduction cannot be more than one half of a public sector monthly pension.
WEP reductions can affect both spouse and dependents.
Normal spousal benefits are between 35% and 50% of the worker’s full retirement age benefit including any WEP reductions. A $400 per month WEP reduction for a worker would translate into a $140 to $200 (35%-50% of $400) reduction for a spousal benefit depending on when the spouse claimed the benefit. Dependent benefits of 50% are similarly reduced as are the total family benefit maximums of 150-188%.
Survivor benefits are, however, exempt from the Windfall Elimination Provisions.