Social security: collecting early

More from Money Magazine

Correcting your credit report gets easier Cut your cooling costs by 30% or more After Obamacare's launch, a look ahead

Best Places to Live Current Issue Subscribe to Money

Top things to know What should I do first? How should I invest? The virtues of the 401(k) The IRA advantage When you switch jobs Make your nest egg last

NEW YORK (Money) -- Question: I started collecting Social Security last year, but I'm still working and Social Security payroll taxes are still being deducted from my earnings. Am I entitled to have my Social Security benefit recalculated based on the payroll taxes I've been paying since I've begun collecting? - Ken Kass

Answer: I can tell from your question as well as lots of others I receive that many people are uncertain about how working while collecting Social Security affects their benefits. And in particular there's a lot of misinformation floating around about what happens when people who begin collecting Social Security early and work have some of their benefits withheld.

This sort of confusion is never a good thing, but it's especially problematic now because so many people are already working in retirement or planning to do so. So I'm happy to answer your question. To do that, however, I'm going to start with something called the Social Security earnings test.

This may not seem at first to be applicable to your question, but by starting with this issue, I'll be able to clarify other misunderstandings people have about work and Social Security and also get to the specific issue you raise. Basically, the earnings test says that if you begin collecting Social Security before you reach full retirement age your monthly benefit will be reduced by $1 for every $2 you earn over the annual earnings limit, which is $12,960 this year and increases to $13,560 in 2008. Depending on when you were born, full retirement age can be between 65 and 67. Click here to see yours.)

In the calendar year that you reach full retirement age, a different earnings test applies, a higher one that gives you much more leeway. Your benefit is reduced by only $1 for every $3 you earn over $34,470 this year and $36,120 in 2008. (For a calculator that shows you how much your benefit would be reduced based on your age and earnings, click here.)

In the month you actually reach full retirement age, these reductions no longer apply.

So once you hit full retirement age, you can earn as much as you want without any reduction in your benefit. (There is a slight twist to these rules to prevent someone who retires in the middle of a work year who exceeds the annual earnings limit from losing benefits. For details on this twist as well as a more detailed look at how the earnings limit works, click here.)

Despite what you typically read in the press, however, you don't actually "lose" the benefits you give up when you go over the earnings limit. Your monthly benefit will be increased in the future in one or, possibly, two ways.

First, the Social Security administration effectively gives you a credit for each month that you miss a check or receive a partial check because you exceed the earnings limit. When you reach your full retirement age, the Social Security administration then boosts your payments to reflect those credits. As long as you live roughly until life expectancy, you'll get at least enough in total payments to compensate you for the earlier cuts - more than enough if you live beyond life expectancy.

For an example of how this works, check out the "Will Working Lower My Social Security" graphic in my "Working In Retirement" story in Money's November cover package.

But there's also a second way your payment could be boosted because of the money you earn while collecting Social Security. And this second adjustment can come into play anytime that you're working and receiving Social Security benefits, regardless of whether your benefit is reduced by the earnings limit.

Here's how this second adjustment works.

To calculate your monthly payment, the Social Security Administration takes into account the highest 35 years of earnings during your career. (Earnings in earlier years are adjusted to reflect rising wage levels, so that $20,000 earned in say, 1980 is increased to reflect its equivalent earning power today.)

So if you had worked, say, only 33 years before collecting Social Security and then worked two years after receiving Social Security payments, your benefit would be increased to reflect the two additional years on your work record.

For that matter, even if you had worked the full 35 years but had, say, two years of earnings in retirement that exceeded your adjusted earnings for two years during your career (perhaps you earned a pittance your first few years in the workforce or had some years when you worked only part of the year), then your two years of retirement earnings would replace the two years of lower earnings during your career, and your benefit would go up. If your retirement earnings in any year justify an increase, then your payment is automatically boosted the next year.

Bottom line: People who collect Social Security benefits early and then have checks withheld or reduced because they exceed the earnings limit don't just lose those benefits. And the money you earn at any time after collecting Social Security could end up automatically increasing your benefits if those earnings boost the lifetime earnings that Social Security uses to calculate your benefit. (If you want to get into the nitty gritty of how your earnings are used to figure your benefits, click here.)

These increases, if warranted, should occur without you having to do anything. But if you haven't received such an increase and you think you're entitled to one - or you're just not sure - you should contact your local Social Security office.

Of course, there's one other way that your Social Security earnings might be affected by working - namely, by boosting your income the earnings could subject as much as 85 percent of your Social Security benefit to income taxes. (For a worksheet to see how much, if any, of your benefit is taxable, see IRS Publication 915: Social Security and Equivalent Railroad Retirement Benefits. And to read about steps you can take to mitigate the tax bite, see the Working in Retirement story I mentioned earlier.

I hope this clears up some of the confusion that seems to surround the issue of working while receiving Social Security. After all, if you're working or expect to work while collecting benefits, you should be planning on the basis on facts, not conjecture and half-truths.