Boomers' eagerness to retire could cost them

They're known as one of the most rebellious generations in U.S. history, not to mention the largest. This year, the oldest of the 79 million baby boomers born from 1946 through 1964 turn 62, which means they become eligible for Social Security. The boomers — projected to live longer than any previous generation of Americans — will have the longest retirements, too.

Can they afford to retire? How far will their Social Security checks go? The reality is this: Many of those who retire early will accept reduced benefits — and in doing so will risk falling short of their financial needs.

So what will this generation of retirees do?

About half of the soon-to-be-62-year-olds are expected to do just what their parents generally did: file for Social Security benefits at the youngest possible age, in exchange for a smaller benefit than they'd get if they waited to retire at 66. Many are relying on conventional wisdom that suggests they're better off filing for Social Security as soon as possible.

Yet if they follow that advice, millions of the oldest boomers may be about to make a colossal error — one that would be magnified by their record-setting longevity.

Over time, taking benefits early could mean a smaller payout, hefty taxes on their retirement savings and a heightened risk of outliving their money. In fact, the roughly 50% of the oldest boomers who the Social Security Administration estimates will tap their benefits starting this year will absorb a permanent 25% cut in benefits.

Up to three-quarters of them are expected to file for benefits before age 66, their full retirement age. How much their benefits will shrink depends on how close they are to full retirement age once they begin to take those benefits.

Now consider those who wait till after age 66: They'll enjoy an 8% annual increase in benefits until age 70. (After that, there's no advantage to delaying benefits.)

Yet on the most fateful financial decision most of them will make, only about 5% of retirees wait until after they've reached full retirement age to claim benefits. And it's a trend that's likely to persist, says Stephen Goss, chief actuary for the Social Security Administration.

Many retirees who plan to start taking their benefits early assume it won't make much difference over time. One of them, John McGinnis, 61, an insurance claims manager in Jacksonville, plans to file for Social Security next year.

"I'm going to take them at the reduced rate, figuring I should live long enough that it will even out to my advantage," McGinnis says.

In reality, boomers who live the longest stand to lose the most by taking benefits early, according to an analysis by the American Academy of Actuaries.

Retirees who file for Social Security at age 62 and live into their mid-90s could lose nearly $150,000 in benefits, says Ron Gebhardtsbauer, senior pension fellow with the academy.

Among the factors that could hurt boomers who take early Social Security benefits at age 62:

• Longevity.

Laurie Ditzel, a retired teacher in Fairport, N.Y., turned 62 on Jan. 5. Most of her older friends filed for benefits once they turned 62. Her own inclination, though, is to wait.

In part, that's because Ditzel, who's also a nurse, might return to work at some point. Under the law, Social Security beneficiaries who haven't reached full retirement age are subject to an "earnings test." It cuts their benefits by $1 for each $2 they earn over an annual limit. In 2008, that limit is $13,560.

That's not the only reason Ditzel says she probably won't file for benefits this year. She also realizes that her retirement income might need to last for decades. An avid traveler and member of a crew team, Ditzel is in excellent health.

"At the moment, I don't really need the extra income, and I'm thinking if I live to be 90, I'll be glad to have the higher (benefit) rates," she says.

In fact, there's a 41% chance that a 62-year-old woman today will live to 90; a 62-year-old man has a 29% chance.

For a married couple, there's a 58% chance that one of them will live to 90 and a 29% chance that one will reach 95.

The Social Security Administration projects that the average retiree's "break-even" age for Social Security benefits is 77. A retiree who dies before then would have fared better by taking benefits at 62. Those who live past 77 would earn more by delaying benefits.

Retirees who take reduced benefits at 62 and live to 90 would lose $39,000 in benefits; those who live to 95 would give up $54,000, the SSA says.

But some financial analysts say your losses would be far greater than that. If, for example, you include the annual cost-of-living increases that boost Social Security checks, Gebhardtsbauer's estimate of how much you'd lose by taking benefits early far exceeds the SSA's: $83,000 for those who take benefits at 62 and live to age 90 and nearly $149,000 for those who live to 95.

Gebhardtsbauer sets the break-even age a bit higher than the SSA does. That's because he takes into account interest earned by those who take benefits starting at 62. Even so, by including the annual cost-of-living increases, he calculates even more value in delaying benefits. The reason: The cost-of-living adjustments will apply to a larger sum.

Thanks to compounding, "those cost-of-living adjustments will be huge, especially if you live long in retirement," says James Mahaney, a retirement specialist at Prudential Financial.

Even if you're convinced you won't live so long, taking your benefits early could hurt your spouse.

When a married beneficiary dies, the survivor can continue receiving his or her own benefit or the deceased spouse's benefit, whichever is more. So spouses who take their benefits early don't just shrink their own payouts; they also reduce the amount the surviving spouse will be eligible for.

• Taxes.

Analysts generally urge retirees to delay withdrawing money from their 401(k), IRA and other retirement savings accounts as long as possible. That way, the thinking goes, the tax-deferred investments can grow and compound. But that advice, Mahaney says, ignores the punishing effect of taxes on Social Security benefits.

If all your income comes from Social Security, your benefits usually aren't taxable. But retirees with other income, including withdrawals from most retirement plans, could owe taxes on a huge chunk — 50% to 85% — of their benefits.

The tax was originally designed to target wealthy seniors. But because the income thresholds weren't indexed to inflation, the tax has spread to middle-income retirees.

Married couples with $32,000 in combined income face taxes on half their Social Security benefits.

Couples with a combined income of at least $44,000 could owe taxes on 85% of their benefits. (For the purposes of the tax, combined income includes half of a retiree's Social Security benefits, wages from a job, pensions and withdrawals from most retirement plans.)

The phenomenon has been termed a "tax torpedo." Yet for some retirees, it will more closely resemble an intercontinental ballistic missile. "People are going to be walloped," Mahaney says.

How can retirees avoid this nightmare? By using their retirement savings to pay living costs in the early years of retirement, Mahaney says, and then taking their Social Security benefits later.

Those who do so will give up some tax-deferred investment gains. But in the long run, Mahaney says, it'll pay off: "It makes no sense to be creating more and more (tax-deferred) dollars that are going to be taxed at higher and higher rates."

To illustrate, Carlson and Mahaney compared two hypothetical retired couples. Both have pretax income of $69,000. But the first couple has Social Security income of $24,000 and IRA income of $45,000. The second has $39,000 in Social Security income and $30,000 from an IRA.

Both couples will pay taxes on their Social Security benefits. But because the first couple has a larger IRA withdrawal, a bigger slice of their benefits will be taxed.

The result: The first couple will pay more than $8,900 in federal and state taxes. The second couple? Only about $4,700.

A bird in the hand

Despite the lure of larger benefits, many retirees can't resist passing up the opportunity to file at 62, in part because they're worried about the future of Social Security.

Eddie Papps, 61, an independent contractor who has lived all over the USA and is currently working in Sarajevo, Bosnia-Herzegovina, plans to retire next year. He and his wife will receive small pensions.

Papps also has savings from his 401(k) plan. Papps says he doesn't really need Social Security income. But he plans to start taking his benefits next year anyway, just to be safe.

He says he thinks Congress will act to shore up Social Security, perhaps by cutting future benefits. But he believes those cuts won't affect people already receiving benefits. Therefore, "I'm not going to take a chance by waiting until I'm 65."

Robert Little, 61, a systems analyst in Philadelphia, feels the same way. He plans to retire from his full-time job this year so he can volunteer at the Philadelphia Zoo and spend time with his grandchildren. And he plans to file for Social Security this year, even though he knows his benefits will be reduced.

"No matter who gets in the next (presidential) administration, they're going to be attacking Social Security," he says.

"It's better to be on the rolls, because there's less of a likelihood they'll do damage to those already getting it."

Unless Congress acts, by 2017 Social Security will start paying out more in benefits than it receives in tax revenue.

By 2027, it will have to tap its trust fund to pay benefits. And by 2041, Social Security will be able to pay only about 75% of promised benefits, according to the agency's report to Congress.

But the 79 million people born from 1946 through 1964 represent an extraordinarily potent voting bloc. Reducing their benefits "would be a huge political burden," Prudential's Mahaney says. He thinks lawmakers are more likely to raise payroll taxes on workers than reduce benefits for retirees.

David Certner, director of federal affairs for AARP, doesn't think that retiring boomers will suffer cuts in benefits, either.

"We think Social Security benefits, particularly for those at or near retirement, are well-financed and will be there," he says.

Some don't have option to wait

Yet even if retirees are convinced their benefits are safe, most of them, Certner predicts, will continue to file claims before full retirement age. Many who are in poor health or have been pushed into early retirement don't have the option of waiting until 66 to file for benefits, he notes.

"For millions, (Social Security) is basically their only source of income," Certner says. "We don't see that changing much."

And even though many analysts say boomers could bolster their financial security by working longer, employers don't always comply. Some companies dangle incentives to induce older employees to leave.

Peter Wagner, 61, who lives outside Kingman, Ariz., retired last year after his employer, Frontier Communications, offered him an incentive to retire before age 65.

"It wasn't exactly a golden parachute," he jokes. "It was kind of bronze."

Social Security benefits, which he plans to start receiving this year, will supplement his savings and buyout package, he says. Wagner's wife, Gail, died in December at age 53. Her death, he says, has reinforced his determination to enjoy the time he has left.

"I'm doing all the things I like to do," says Wagner, an avid hunter and fisherman. "I've got over 20 acres and all kinds of projects I've been trying to do for years."

Even with early-retirement incentives from their employers, boomers who stop working risk running out of money — a risk that could escalate if they take Social Security benefits early.

But that's a chance that many older boomers seem willing to take.

"The bottom line is, people would still prefer to retire than work," Certner says. "People can't wait to get to age 62 and get out."