Quite a number of retirees are receiving a lump-sum payment when they apply for Social Security benefits, and that led one financial adviser in San Leandro, Calif., to ask me to explain these mystery payments.
“I have been hearing from clients and others that the Social Security Administration has been writing big checks to those who apply for their benefits a few months after they turn 66,” Nancy Woodall, president and chief compliance officer of Meridian Investment Counsel Inc., wrote in an e-mail. “I am hoping that you can shed some light of why this is happening.”
Yes, the SSA is able to offer beneficiaries who apply for benefits after they reach their full retirement age up to six months of lump-sum benefits beginning the month they turn 66. But the SSA can't pay retroactive benefits for any month before full retirement age or more than six months in the past.
For example, if someone applied for Social Security retirement benefits at 66 and six months, they could receive a lump-sum payment for six months, and their future benefits would be based on claiming at their full retirement age of 66. But if they applied for benefits at 66 and three months, they could receive only three months of retroactive benefits as a lump-sum payment.
The retroactive benefits aren't mandatory.
For some people, the lump-sum payment is an attractive bonus that might fund a long-awaited retirement trip. Others may want to skip the one-time lump payment and opt for larger benefits going forward, which would also create a larger base amount for future cost-of-living adjustments.
But no double dipping. So someone who claimed benefits at 70 could either choose to receive a lump sum for six months and future benefits based on claiming at 69 and six months or forgo the lump sum and receive larger future benefits based on claiming at 70.
Keep in mind that Social Security benefits may be taxable, and a lump-sum payment could boost the amount of benefits that are taxed.
Individuals must include the taxable part of a lump-sum retroactive payment of benefits received this year in their 2013 income, even if the payment includes benefits for an earlier year, according to Internal Revenue Service Publication 915, “Social Security and Equivalent Railroad Retirement Benefits.”
Up to 50% of Social Security benefits are taxable if total “provisional income,” which includes adjusted gross income, tax-exempt interest and one half of Social Security benefits, exceeds a base amount: $25,000 for single taxpayers and $32,000 for married taxpayers filing jointly.
A second tier of income tax — reaching up to 85% of Social Security benefits received — kicks in for single taxpayers with provisional income of more than $34,000 or for married taxpayers filing jointly with provisional income of more than $44,000.
Generally, individuals use their 2013 income to figure the taxable part of the total benefits received this year.
However, they may be able to figure the taxable part of a lump-sum payment for an earlier year separately, using income for the earlier year, the IRS publication explains.
That way, people can take advantage of the exemption amount in the provisional-income formula for both years. They can elect this method if it lowers their taxable benefits.
The IRS publication cautions that because the earlier year's taxable benefits are included in 2013 income, no adjustment is made to the earlier year's return. That means an individual shouldn't file an amended return for the earlier year.
So if clients have surpassed their normal retirement age but haven't yet collected their Social Security benefits, an adviser might suggest the lump-sum Social Security retroactive-benefit option.
It may be ap-propriate for those who don't intend to wait to collect the maximum benefit amount at 70 but who haven't gotten around to filing for benefits yet. And it could be a better alternative than dipping into their savings or taking out a home equity loan to finance that retirement celebration cruise or kitchen update.
But don't forget to warn clients about the possible tax bite.