Barbara O'Neill: 403(b) Plans and Social Security

July 18, 2023

By Barbara O'Neill, CFP®, AFC®

In a previous post, I described the “3-legged stool” metaphor used to describe retirement planning. The stool analogy indicates that there are three primary sources of income in later life: Social Security, pensions, and personal savings (e.g., 403(b) plan, individual retirement account (IRA), and taxable account). 

The 3-legged “stool” is very wobbly for many 403(b) plan participants. Only 1 in 5 teachers get a full pension and more than half of those who teach never get any pension at all because they don’t work long enough. In addition, nearly 40% of teachers are not covered by Social Security. That’s more than one million teachers, as well as other public sector employees (e.g., school support staff), some railroad employees, and federal government employees hired before 1984 with a Civil Service Retirement System (CSRS) pension.

This post delves into Social Security as a foundational source of income for many 403(b) plan participants. It describes how benefits are earned, calculated, and taxed, the Social Security earnings limit, why many public employees are not covered, non-teaching routes (e.g., a second job or sideline business) to earn Social Security coverage, unique benefit formula rules for people whose primary job isn’t covered by Social Security, and relationships among Social Security, pension, and 403(b) plan income. It also includes studies about teachers’ retirement date timing, as well as three “need to know” facts and six take-away action steps.

Social Security Basics

Payroll Deductions — Social Security was designed to be “a base to build on” and covers 96% of the U.S. workforce (about 180 million workers) who earn “credits” toward future benefits when they work and pay Social Security tax. Forty credits (10 years of work) are needed to qualify for retirement benefits. Each $1,640 in earnings (2023 figure; adjusted annually for inflation) provides one credit and workers can earn up to four credits per year (e.g., $1,640 x 4 = $6,560). Workers pay 7.65% of gross income for FICA (Federal Insurance Contributions Act) tax: 6.2% (Social Security) and 1.45% (Medicare). Employers match these percentages (15.3% total). There is a maximum wage on which taxes are paid: $160,200 (2023 figure; adjusted annually for inflation).

Benefit Calculations — Social Security benefits are based on earnings throughout a worker’s entire career. First, workers’ wages are adjusted for changes in wage levels over time. Next, a monthly average of the 35 highest earnings years is calculated. If there are less than 35 years of earnings, years with no income are recorded as “0” in the average. The result is a worker’s average indexed monthly earnings (AIME), which is used in a formula to compute the primary insurance amount (PIA). The PIA formula determines benefits that are paid.

Key factors that determine benefits paid are workers’ indexed earnings and the age at which benefits begin. For workers born in 1960 and later, early benefits at age 62 are reduced by 30% (e.g., $700 at 62 vs. $1,000 at full retirement age of 67). For older workers, benefit reductions at age 62 are between 25% and 29.17%.

Social Security Statements — Workers can receive a personalized retirement benefit statement by opening a my Social Security account. The statement includes a bar graph that displays projected monthly retirement benefits at nine different ages ranging from 62 to 70. The longer someone waits to claim benefits, the higher the benefit amount. For example, benefits at age 70 are 76% higher than at age 62, before cost-of-living adjustments (COLAs).  The statement also includes a projected amount for Social Security disability benefits (if qualified) and a worker’s career earnings history to review earnings taxed for Social Security and Medicare.

Starting Date — A key decision in later life is when to start Social Security benefits. Factors to consider include health status (claiming early makes sense with a short life expectancy), other income sources (e.g., pension, 403(b), self-employment), financial need, and anxiety over Social Security’s future. Before full retirement age (FRA), benefits are permanently reduced by 5/9 of 1% per month for the first 36 months and 5/12 of 1% for each added month. After FRA to age 70, delayed retirement credits accrue at 0.66% per month (8% per year).

Another metric used to time Social Security filing is break-even age. This is the age when someone who starts benefits later (e.g., FRA or age 70) catches up with the cumulative benefits of someone who started receiving benefits at an earlier age. Depending on the ages compared and the assumptions used, break-even is usually around ages 78 to 82. A number of break-even calculators can be found by searching online.

Earnings Limit — The Social Security earnings limit applies when benefits are claimed prior to FRA. The amount of benefits forfeited is $1 for each $2 earned above $21,240 (2023 figure; adjusted annually for inflation). In the year someone reaches FRA (e.g., age 67 if born in 1960 or later), the forfeiture amount is $1 for every $3 above $56,520 (2023 figure). Upon reaching FRA, an unlimited amount of money can be earned without forfeiting any benefits. It generally does not make sense to claim benefits early if you expect to exceed the earnings limit.

Taxation of Benefits — Many Social Security recipients must pay income tax on a portion of their Social Security benefit because the income threshold amounts were never indexed for inflation since Social Security taxation began in 1984! The starting point to determine if benefits are taxable is combined (a.k.a., provisional) income: adjusted gross income + nontaxable interest + ½ of Social Security benefits. The threshold amounts are as follows:

• Tier 1 - If combined income is $25,000 to $34,000 (single tax filers) or $32,000 to $44,000 (married filing jointly), up to 50% of Social Security is taxable.
• Tier 2 - If combined income is more than $34,000 (single) or $44,000 (joint filers), up to 85% of Social Security is taxable.

If not a concern at the start of retirement, taxation of Social Security may become an issue when older adults are widowed and must file as single taxpayers and/or when required minimum distributions (RMDs) begin.

Social Security Resources

The Social Security Administration (SSA) has a comprehensive website (www.ssa.gov) where people can check eligibility for benefits, apply for benefits online, and learn about Social Security and Medicare. Personalized retirement benefit estimates and benefit status checks can be done with a my social Security account (www.ssa.gov/myaccount/). SSA also has a number of online calculators for calculations related to life expectancy, retirement age, the earnings test, and more (https://www.ssa.gov/benefits/calculators/). 

Social Security and Public Employees

As noted above, about 40% of public K-12 teachers (and others) are not covered by Social Security. Their employer does not deduct FICA tax from their paycheck and, unless they qualify for benefits through an alternative route, they have no Social Security to fall back on in later life. In addition, they will receive bills from Medicare for Part B and D premiums because there is no Social Security check to deduct them from.

Why does this happen? When Social Security began in 1935, government workers were excluded. In 1950, state and local government workers were allowed- but not required- to participate and, in 1984, federal workers were placed in a new retirement system (FERS) with mandatory participation in Social Security. Social Security coverage for teachers has been a “mixed bag” for almost 75 years: 33 states opted-in to Social Security, 13 states (including DC) opted out, and 5 states allow school districts to opt-in or opt-out.

Teachers (and other public employees) in “opt-out” states can still earn 40 quarters of coverage and qualify for Social Security. How? 1. taxed earnings prior to a teaching career, 2. taxed earnings after a teaching career, and/or 3. taxed earnings during a teaching career (e.g., side hustles). Their benefit will likely be low, however, because quarters are earned as a young adult or part-time freelancer. However, with a pension- which workers in “opt-out states” must have- part of their benefit will be erased by the WEP. See below.

Windfall Elimination Provision (WEP)

The windfall elimination provision (WEP) was enacted in 1983 as part of Social Security reform. It was designed to calculate benefits in a different way for workers whose primary job wasn’t covered by Social Security to distinguish them from long-term, low-wage workers who earned a similar amount. The WEP works by adjusting a key number in the PIA benefit calculation formula for workers without 30 or more years of substantial earnings ($29,700 in 2023, adjusted annually for inflation). 

The WEP reduces Social Security benefits that workers with a pension would otherwise earn. Some people claim it is unfair to those who worked the required time (even if not at a primary job). Others say it avoids “double dipping.” The maximum WEP benefit reduction for workers with 20 years or less of substantial earnings (in 2023) is $558 with smaller WEP reductions for 21 to 29 years of substantial earnings.

Government Pension Offset

Another Social Security benefit adjustment for non-covered workers with a pension is the government pension offset (GPO), which applies to those entitled to Social Security benefits as a survivor or spouse. The GPO reduces benefits by two-thirds of a government pension, which often erases any spousal benefit at all.

Social Security and 403(b) Plans 

While Social Security and 403(b) plans are not directly related, they affect each other in several ways:

• 403(b) plans provide a “three legged stool” of retirement income when plan participants have both a pension and Social Security.
• If significant 403(b) savings results in four- or five-figure annual RMDs, plan participants will likely pay income taxes on Social Security, especially if they also have a pension.
• 403(b) plans are key back-up for Social Security benefits that are significantly reduced by the WEP and GPO and pension benefits that have been eroding over time due to state underfunding.

Research Results

Two recent studies investigated the impact of Social Security rules on decisions about the timing of retirement age. One study found that age 65- the old FRA for people born before 1943- is still “sticky” even after decades of progressively increasing to age 66 and then 67. Results indicated that most workers still timed their work force exit at age 65. Another study also found higher rates of retirement among covered (by Social Security) teachers at Social Security eligibility ages. 

Three (More) Things

• Cost of living adjustments (COLAs) index Social Security benefits for inflation. The COLA calculation for each new year is based on consumer price index changes in the third quarter of the previous year.
• Social Security benefit statements don’t account for the WEP and GPO. Workers who are affected by these benefit reductions need to use specialized planning tools like the SSA online WEP calculator.
• If workers affected by the WEP start Social Security while working, they will receive a full (unreduced) benefit based on their work history. WEP reductions do not start until public pension benefits begin.

Case Example: Me

I started work for Rutgers Cooperative Extension in 1978. My position included federal funding so I was placed in the Civil Service Retirement System (CSRS). For 41 years, 4 months, 7% of my pay was deducted for CSRS and I did not contribute to Social Security. I had nine years of Social Security coverage from 1970-1978, followed by 13 “0” years from 1979-1991. I started Money Talk in 1992 as a side hustle and began paying FICA tax again. By the mid-1990s, I earned the 40 quarters of coverage necessary to receive future retirement benefits. Since 1992, I’ve earned income as a self-employed financial education entrepreneur.

Fast forward two decades. I started Social Security in November, 2018. By then, I had 34 years of earnings and wanted to get a full benefit before I left Rutgers, started CSRS, and the WEP kicked in. For 14 months, I received $695. I left Rutgers in December, 2019 and my benefit was reduced by the WEP to $308 in January, 2020. It took SSA five months to figure everything out, however, and by then I had a $1,544 overage. My choices were: write a check to SSA or pay my “debt” in monthly benefit deductions. I chose the latter. My monthly benefit was then less than $100 after subtracting “debt” payments and Medicare premiums. Today, with benefit increases from three years of full-time self-employment (now replacing low-earning years from my teens and early 20s) and deductions for Medicare, my monthly benefit is $184.80. Mathematically, I will not work long enough to totally eliminate the WEP, but I’m okay with that. Maybe future legislation will.

Six Smart Strategies

No. 1: Maximize Your Social Security Benefit — Common ways to do this include earning a higher “day job” income, sideline income, working until an older age, and waiting until FRA (or up to age 70) to earn delayed retirement credits and higher benefits.

No. 2: Save Aggressively — Public employees without no or low Social Security coverage and/or an inadequate pension need back-up funding with individual savings. This includes savings in a 403(b) plan and/or a Roth or Traditional IRA.

No. 3: Estimate Benefits Periodically — Standard SSA benefit estimates don’t reflect the WEP reduction for public employees with 40 quarters of  coverage. The WEP calculator from SSA and similar online tools provide a realistic benefit estimate.

No. 4: Withhold Taxes on Social Security Income — Most middle-income retirees pay tax on part of their Social Security benefits. The SSA will withhold taxes if directed to do so. Otherwise, quarterly estimated tax payments are required.

No. 5: Earn Post-Public Sector Income — An “encore career” provides an opportunity to boost Social Security benefits by replacing “0” and low-earning years in the 35-year career benefit calculation formula.

No. 6: Keep Current with Social Security Changes — Future changes are likely to keep Social Security sustainable. Otherwise, benefits could be cut by almost 25% if modifications are not made by Congress by 2034.

In Summary

Social Security is a key component of retirement income for most Americans. Sadly, many 403(b) plan participants are excluded. It is important to understand how benefits are earned, calculated, claimed, and taxed.

This post provides general personal finance information and does not address all the variables that apply to an individual’s unique situation. It should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.

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Dr. O'Neill is the owner/CEO of Money Talk: Financial Planning Seminars and Publications where she writes, speaks, and reviews content about personal finance. She is a Distinguished Professor Emeritus at Rutgers University and a long-time 403(b) plan participant.

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