Do 401k and IRA Contributions Reduce My Social Security Benefits?

A reader writes in, asking:

“I’m in a high tax bracket, so I’ve been making pre-tax contributions to my 401k. But it now occurs to me that if doing so reduces the amount of earnings reported to Social Security, then it will eventually reduce my Social Security benefit in retirement as well, correct? If so, wouldn’t that be one reason in favor of using Roth contributions instead? And shouldn’t this be a part of the ‘Roth or traditional IRA’ question that gets so much discussion?

Also, I signed up for the new online Social Security statement to check my earnings record and estimated benefits. Which number from my tax return is the earnings for each year supposed to match?”

Checking Your Earnings Record

If you worked as an employee, the figure that should show up for a given year’s earnings record on the Social Security website is the number from box 3 (“Social Security wages”) from your Form W-2  for the year. If you had multiple jobs, it should be the total of all your box 3′s. The reason they don’t use box 1 is that the calculation for box 1 includes reductions for things like pre-tax 401(k) contributions, which reduce income taxes but not Social Security taxes.

If you were self-employed, the figure that should appear on your Social Security earnings record is line 4 (“net earnings from self-employment”) from Schedule SE. Note that this amount is not the same as the profit from your business. Rather, it’s 92.35% of the profit from your business, to account for the deduction you get for one-half of your self-employment tax.

What Effect Do IRA and 401(k) Contributions Have?

As mentioned above, pre-tax contributions that you make to an employer-sponsored retirement plan such as a 401(k) reduce your income tax, but they do not reduce your Social Security tax. The same goes for traditional IRA contributions, as well as contributions to a SEP or SIMPLE IRA.

And because they have no effect on the amount of your income that’s subject to Social Security taxes, pre-tax contributions to an IRA, 401(k), 403(b), etc. do not reduce the Social Security benefits that you will eventually receive.

May 16, 2012 2 Comments

Checking (and Correcting) Your Social Security Earnings Record

The Social Security Administration used to send a statement each year that included your earnings record by year, as well as an estimate of what your Social Security retirement benefit would be if you claimed it at age 62, at full retirement age, or at age 70.

Then, in 2011, the SSA stopped sending those statements in an attempt to save on costs. At the beginning of this month, however, the SSA announced that you can now get your statement online at SSA.gov/mystatement (after jumping through some hoops to verify your identity, that is).

(Related note: The SSA also announced that annual paper statements have been resumed for people age 60 or over who are not already receiving benefits, and a single paper statement will be sent to people in the year they turn 25.)

Checking Your Earnings Record

Even if you’re a long way from retirement and are not currently concerned about getting an estimate of your Social Security retirement benefits, I’d encourage you to go ahead and create an account for the purpose of checking your earnings record. Mistakes happen, and it’s best to get them fixed as quickly as possible.

Please note, however, that according to the SSA, if your record is missing earnings from this year or last year, it’s not necessarily a problem. Most likely, it simply means that the earnings haven’t been recorded just yet. They should appear on a later statement.

Correcting Mistakes in Your Earnings Record

If you find that your earnings record is missing earnings (other than those from this year or last year), you’ll want to find something that documents the correct amount of earnings, for example:

  • Your Form 1040 from the year in question,
  • Applicable Forms W-2,
  • Applicable pay stubs, or
  • If you were self-employed, Schedule C or Schedule SE from that year.

Once you’ve found something documenting your earnings, you’ll want to call the SSA to get things straightened out as soon as possible.

Where to Find Earnings Documentation

If you no longer have anything documenting your earnings for the year in question, you could call your employer from that year to see if they’ll send you your W-2 or, failing that, some other sort of payroll record.

Alternatively, you can order a transcript of that year’s tax return from the IRS. A tax return transcript includes most information that was filed on your return for the year, including any accompanying schedules or forms. You can request a transcript in any of three ways:

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May 14, 2012 2 Comments

Investing Blog Roundup: More Tips on Leaving Your Broker

In response to Wednesday’s article about leaving your broker, two readers shared related tips that might prove valuable:

  • Evan of My Journey to Millions mentioned that if you’re moving a taxable account, you’ll want to gather and keep your cost basis information because it might not get transfered properly to your new brokerage firm, and
  • An anonymous reader cautioned against using a close friend or family member as a financial advisor, because you want to be able to leave your advisor/broker whenever it makes financial sense without having to worry about social repercussions.

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May 11, 2012 1 Comment

How to Leave Your Broker

A reader writes in, asking:

“I have a few accounts with a broker at Edward Jones. He was recommended by a family member, and he hasn’t tried to cheat me in any way. But I don’t think the service I’m receiving is sufficient to justify the commissions I’m paying. Having read about Vanguard and index funds, I think that’s where I’m headed.

But I don’t actually know how to move my money. Do I just call my Jones guy and tell him I’m leaving? I don’t relish the thought of that conversation.”

To transfer an account from one brokerage firm to another, you don’t actually have to call your current advisor/broker first. In fact, you may not have to call him at all. And to the extent possible, I’d suggest avoiding it. The receiving brokerage firm (in this case, Vanguard) has an incentive to be as helpful as possible, whereas the company you’re leaving has an incentive to make things difficult and/or give you a sales pitch to get you to stay.

What you’ll want to do is originate the process at the receiving brokerage firm. Either open an account online (choosing during the application process that you have an account you want to transfer over), or give them a call and explain what you want to do.

The receiving brokerage firm will give you the appropriate paperwork to sign. Once you sign it and send it back in, they forward it to your old brokerage firm and handle the process from there.

Getting a Medallion/Signature Guarantee

Some brokerage firms (including Edward Jones) will require a “signature guarantee” (sometimes called a “medallion guarantee”). This is not the same thing as having your signature notarized, as it has to be done by certain employees of a financial institution such as a bank or brokerage firm. Most places will only provide a signature guarantee if you have an account with them, but I’ve heard of some credit unions offering to do it for anybody.

Before heading to your bank, I would suggest that you call ahead, because it’s often the case that only a certain manager can provide a signature guarantee, and you wouldn’t want to make the trip only to learn that the right person isn’t at work that day.

Transfer “In Kind” or Liquidate Everything First?

As part of the transfer process, the receiving brokerage firm will typically ask if you want to:

  1. Bring things over “in kind,” or
  2. Have your old brokerage firm liquidate everything and send it over as cash.

If the account is an IRA and there are no fees to sell any of the holdings, it’s probably simplest to have everything liquidated and moved over as cash.

Conversely, if the account is an IRA and there will be fees to sell any of the holdings, it’s usually best to compare the cost at each brokerage firm and do it wherever it will be less expensive.

Finally, if you’re transferring a taxable account, you’ll probably want to bring things over “in kind,” because liquidating everything would result in capital gains/losses. After everything is transfered over, you can go through the holdings one by one to see which ones should be sold immediately, which ones should be sold later (after a short-term capital gain has become a long-term capital gain, for instance), and which ones should be kept.

May 9, 2012

Do I Need Emerging Markets Stocks?

A reader writes in, asking:

“I currently own Fidelity’s Spartan International Index Fund. I only recently realized that the fund doesn’t own any emerging markets stocks at all. I realized this because I just learned about Fidelity’s new international fund, Spartan Global ex U.S. which does include emerging markets.

Should I switch to the Global ex U.S. fund? Or should I forget about it?

I’m retired and consider myself risk-averse.”

To put it as concisely as possible: It probably doesn’t matter very much.

As a general principle, it usually is beneficial to be as broadly diversified as possible with regard to one’s stock holdings. So, all else being equal, I’d usually be inclined to use the fund that includes an allocation to emerging markets.

But, in this case, all else isn’t equal. This may change in the future, but for the moment, the new Spartan Global ex U.S. fund is slightly more expensive than the Spartan International Index fund: 0.24% expense ratio as compared to 0.11%, according to Morningstar.

Admittedly, that’s not a large difference. But neither is the difference in allocation that you get for the additional cost. According to Morningstar, Fidelity’s Spartan Global ex U.S. fund only has 16.2% of its portfolio invested in emerging markets. (For anyone curious, Vanguard’s Total International Stock Index Fund also has 16.2% in emerging markets.)

If, say, 18% of your portfolio is invested in international stocks (30% of the stocks in a 60/40 stock/bond allocation, perhaps), that would mean we’re only taking about changing 2.9% of your total portfolio (16.2% of 18%). And the change isn’t even from stocks to bonds (or vice versa). It’s from one type of stocks to another type of stocks.

[Side note: Even if we change the assumptions to represent an aggressive investor with a 100%-stock portfolio, half of which is international, we'd still be talking about just over 8% of the portfolio.]

In other words, it’s probably not something you have to worry a great deal about one way or the other.

To give an idea of how similar two such funds can be, here’s the performance of Vanguard Total International Stock Index Fund (with its ~16% emerging markets allocation) as compared to the performance of Fidelity’s Spartan International Index Fund (with 0% emerging markets) from 12/15/2010 (when the Vanguard fund changed to its current index) to 5/3/2012.

It’s the kind of difference that most investors probably wouldn’t even notice — especially if the international allocation is a fairly small part of the overall portfolio.

In short: You can pay slightly more in order to get a slightly more diversified allocation. Or not.

May 7, 2012

Investing Blog Roundup: Should You Be Picking Stocks?

As regular readers of this blog know, I’m generally of the opinion that it’s a mistake to pick individual stocks rather than use low-cost, diversified index funds (or ETFs). That said, there are a few exceptions. This week, Rob Berger of Dough Roller made a good case for one of them:

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Thanks for reading!

May 4, 2012
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