Most retired workers depend on multiple streams of income during their retirement. Two of the most common such income streams are Social Security and pensions. If we look at pension vs. Social Security income, we find significant differences. Retired workers need to understand the key differences between the two programs. They are funded, structured and taxed differently. If you’re planning for retirement be sure to make use of the insights of a financial advisor.
Pensions Defined
Approximately 44% of Americans are currently covered through their companies by a defined benefit plan. Defined benefit plans have been closed down at many companies and today only 4% still offer them. However, they still pay out the benefits for Americans still living and retired on these plans. They have largely been replaced by defined contribution plans, which are 401(k)s and IRAs.
Pensions are meant to be retirement plans, unlike Social Security. Their purpose is to provide a benefit to their retired workers that is large enough to live on. Of course, the benefit depends on their age, years of service and salary during their employment. There may be a vesting requirement. In other words, you may have to stay with the company for some predetermined time period, sometimes five years, to be vested. Social Security has no vesting requirements. Spouses may get a partial payment from the pension if the retired worker passes away, but there is usually no benefit to minor children or dependent parents like there is with the Social Security program.
You can usually start collecting pension benefits if you retire at age 55. You have to wait until you are at least age 62 to begin collecting Social Security benefits. Also, there is no disability insurance program associated with defined benefit pensions like there is with the Social Security program. Social Security pays a small death benefit, but pensions have no such feature.
Some defined benefit pensions will distribute your funds to you as a lump sum. You can choose whether to take the lump sum or opt for the monthly benefit payments. You don’t have this option with Social Security.
Social Security Defined
The Social Security program is not a pension and was never intended to be a pension. It is a social insurance program administered by the U.S. federal government. It was always supposed to be supplemental income in retirement for workers who are covered by it, although we know that there are many Americans who live almost exclusively on their Social Security checks. There are two Social Security trust funds that were established by the federal government. The Social Security benefits paid at retirement come from the Old Age and Survivor’s Fund. This fund also pays out survivor’s and spousal benefits as well as the retirement benefit.
The Social Security retirement benefit is similar, in many respects, to a pension. It pays a monthly benefit to retired workers much like a defined benefit pension plan. Individuals and companies contribute to that system through a payroll tax. The amount you pay to Social Security is shown on your check stub on the line item FICA, the Federal Income Contributions Act. Employed individuals pay 6.2% of their wages to Social Security and their company pays 6.2% for them. Self-employed individuals pay the entire 12.4%.
There are three sources of funding for Social Security. The first is the payroll tax. Social Security is also funded by interest on excess contributions held by the U.S. Treasury and, thirdly, taxes paid on benefits by current beneficiaries. The payroll tax funds the majority of the Social Security fund.
The amount of Social Security benefits that a retired worker receives depends on the number of years they worked and the total salary they received. It also depends on the age of the worker when they start drawing benefits. If you retire when you are at your retirement year, you will receive your full Social Security benefit. But, if you retire between age 62 and your retirement year, your benefits are reduced, depending on your individual situation.
Social Security also pays out a small survivor’s benefit when a retired worker passes away. A widow’s pension or spousal benefits may be paid, but it depends on the individual situation.
Current workers who pay into Social Security fund the benefits for future workers. Social Security is not an entitlement. It is a pay-as-you-go system.
The second part of the Social Security program is the disability insurance benefit. If an individual is disabled and has enough credits, they may be eligible for a disability benefit instead of a retirement benefit.
Pensions vs. Social Security: Key Differences
The Social Security program is not a pension plan. It is a social insurance plan meant to supplement a retired worker’s pension and savings. If a worker has paid into Social Security, they can start drawing benefits at retirement age. The retirement age for Social Security is at least 62 years. For a defined benefit pension, it is usually 55 years. You can sometimes draw out your pension in a lump sum or you can receive the monthly payment. You can’t draw out Social Security in a lump sum.
There is a vesting requirement for many pension plans, but none for Social Security. In the case of the death of a retired worker, the spouse may get a reduced benefit and a small survivor benefit. There are no survivor’s benefits with a pension plan. Social Security may provide a survivor’s benefit to dependent parents and dependent children.
Social Security is funded, primarily, through a payroll tax that most Americans pay. Pension plans are funded privately by a combination of company and employee funds. Social Security has a disability income program, but pension funds do not.
Social Security recipients are subject to a graduated income tax based on their income. Only a portion of Social Security benefits is taxed. All pension income is taxed at your ordinary tax rate although it may not be subject to state tax. If you work after you start drawing Social Security, more of your Social Security can be taxed and at a higher rate. Pension taxation is not dependent on whether you work or not.
The taxation of a pension vs. Social Security income may be different. Thirty-seven states don’t tax Social Security income. If the only retirement benefit you get is Social Security, you will probably not have to pay any tax on it at all. As an individual, if your income is between $25,000 and $34,000, you may have to pay tax on 50% of your income and 85% of your income if it is over $34,000. For a married couple, that income cutoff is $44,000. Pension income is simply taxed at your ordinary tax rate.
You aren’t required to pay Social Security tax above the wage base limit, which is $142,800 in 2021. You do, however, keep paying tax on pension income.
The Bottom Line
Social Security and pension income benefits should be part of an overall retirement strategy. They are similar in some ways but have important key differences, especially in how they are funded, structured and taxed. Treat them as separate parts of an overall retirement portfolio strategy.
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Source: finance.yahoo.com