4 Social Security pitfalls that can cost clients in retirement

Diversity is key when it comes to generating income in retirement, advisors say. But across the board, one source of income reigns supreme for a majority of retirees: Social Security.

Nine out of 10 retirees receive income from Social Security, and more than half say it will be their main source of support for the rest of their retirement, according to the Transamerica Institute. As of July, nearly 56 million Americans were receiving retirement benefits from the Social Security Administration, with the average retired worker receiving just over $2,000 a month in benefits.

Of course, that average can mask big differences from one beneficiary to another. Workers nearing retirement often focus on the age at which they will take Social Security — maximum payments can vary by more than 80% depending on how long a retiree delays taking their benefit — but that's not the only consideration when it comes to maximizing a client's Social Security benefits.

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Other factors, like a client's working history and tax arrangement, can have a significant impact on their Social Security benefits in retirement, often in ways that aren't obvious until it's too late, advisors say. Here are some of the key pitfalls that advisors should know.

A well-intended S corp with big consequences

S corporations are all the rage for small business owners and accountants looking to minimize taxes, but they can create problems down the road when it's time to claim Social Security, advisors say.

Through an S corp, business owners can pay themselves a portion of the company's income as salary and take the rest as a distribution, which isn't subject to payroll taxes like FICA. While this strategy lowers Social Security and Medicare tax obligations, it also reduces the owner's reported Social Security earnings — a critical factor in determining future benefits.

For the right client, an S corp can still be the best move. But advisors say taking that route involves careful consideration.

"For a business owner with $200,000 in income, the owner would save $15,300 annually if they elected to make an S corp election and recognize half of their compensation as profit distributions rather than wages," said Kris Tower, senior managing director at American Portfolios Denver. "If those tax savings are captured and invested, they could lead to a much higher benefit than what would be gained by contributing to Social Security."

Still, without the right guidance, advisors say business owners rarely actually invest the extra income they keep through their S corp.

"For those who want to avoid the FICA tax and take the income as a distribution, the amount saved should be allocated to long-term vehicles," said Erika Safran, founder of Safran Wealth Advisors in New York City. "If the money intended for FICA taxes is not invested, then this is a losing strategy."

Early retirement can present hidden costs

Early retirement can be tempting for high earners, but advisors stress the importance of factoring in how their projected Social Security benefits will look by full retirement age.

People often wrongly assume that their estimated Social Security payment will remain the same, even if they were to stop working earlier than usual, according to Crystal McKeon, the chief compliance officer at TSA Wealth Management in Houston.

"If someone decides to retire early and counts on the Social Security benefit, they may be surprised to learn that the calculation they see expects they will continue working until full retirement age and continue to make the same amount they made in the current year," McKeon said. "If you retire early, your estimated Social Security payment may drop because you are no longer working in years that the original calculation included."

A similar problem can arise when a parent decides to leave the workforce to raise children, according to Marc Shaffer, a financial advisor and CFO at Searcy Financial Services in Overland Park, Kansas.

"Even part-time work during those years can help strengthen their [earning] record," Shaffer said.

Saving on taxes can come at a cost

Reducing tax liability may seem like an easy win, but advisors say the short-term savings can come at the expense of long-term income.

"We walk clients through the tradeoff: Every dollar of net income drives both [Social Security] tax and future benefit," said Mark Stancato, founder and lead advisor at VIP Wealth Advisors in Decatur, Georgia. "Sometimes it is worth lowering earnings, like when using an S corp for material tax savings, but it should be strategic, not accidental."

Donald LaGrange, a financial advisor at Murphy & Sylvest Wealth Management in Rockwall, Texas, said that he has encountered multiple business owners in recent months who have damaged their estimated Social Security payments through overzealous tax deductions.

"Here's basically how it goes once I see how little their [Social Security] benefit estimate appears in comparison to what they've told me they generate in income: 'Well, I told my CPA a long time ago that I hated paying tax.' So, along the way, they took every opportunity to minimize tax/maximize write-offs," LaGrange said. "One owner had purchased a new truck for the business frequently (including the lift kits and wraps, etc.) so he could show the expenses and minimize taxes."

That approach doesn't just shrink projected Social Security benefits — it can also cap contributions to other retirement vehicles, such as a SEP IRA, which is limited to 25% of net earnings, LaGrange said.

International work introduces Social Security complexity

For clients working abroad, the country they're in can significantly affect their Social Security earnings record.

Some countries have totalization agreements with the U.S., which can help prevent double Social Security taxation and may allow work credits earned abroad to count toward U.S. benefits. But rules differ by country, and not all foreign earnings automatically count. Without careful planning, international work can reduce a client's reported U.S. earnings and ultimately lower their future Social Security benefits.

"You may be covered by one or both countries' social benefit programs, but it's best to know what the rules are," said Leslie Beck, owner of Compass Wealth Management in Rutherford, New Jersey.