401k Planning and the 0% Social Security Loan

The chance to use other people’s money (OPM) for free is always a tantalizing proposition worthy of consideration. A 0% loan allows the borrower to use the time value of money to reap a profit by investing the principal amount, returning the principal to the lender when due and pocketing the earnings made. Or, a 0% loan can be used to buy time, for example, to avoid selling off assets in a market decline.

A new report from Boston College’s Center for Retirement Research puts the spotlight on a relatively unknown way that retirees can game the Social Security system for a free loan. In a nutshell, Social Security law allows a person who claims benefits to change his or her mind at a later date, provided the nominal amount of Social security benefits paid to the person are returned (without interest).

Example: a person could take reduced benefits at the earliest possible age (62). Later, he could decide that, being in good health, he would rather have the higher monthly benefit available had he waited to file at full retirement age (e.g. 66). Social Security allows this change so long as the claimant repays the total benefits received between 62 and 66.

CRR notes that the “free loan” loophole in the Social Security law stands to mostly benefit more affluent retirees (who can afford to payback benefits) and could potentially cost Social Security $11 billion or more. Further, the report makes it clear that the glitch is a looming problem for Social Security that should be fixed:

Social Security was not designed to give zero-interest loans to those who can afford to retire without their monthly benefit. The $5.5 billion to $11.0 billion annual gain to high-income households will result in a comparable cost to the Social Security program. Moreover, the system could be at even greater risk in the future because the number of people who could take advantage of the zero-interest loan strategy will increase….In short, the potential cost of this strategy will continue to rise and Social Security will be left with the bill.

Still, while the loophole is available and legal, it is intriguing to consider ways it might be used in an individual’s 401k planning strategy. Here are a few ideas:

1. Scenario 1: Your original plan was to delay taking Social Security until full retirement age (or later) by using 401k monies. Market losses have decimated your 401k and you’ve put retirement on hold. The free loan tactic could help keep your retirement plans on track and provide a window of time for your 401k to recover.
2. Scenario 2: You previously took early Social Security and are now considering taking a reverse mortgage out on your home to provide additional monthly income. Compare whether taking a lump sum reverse mortgage payment and using it “buy” additional Social Security benefits might get you more than taking monthly reverse mortgage payments.
3. Scenario 3: You previously took early Social Security benefits. You now realize you need more monthly income and are debating whether or not to purchase a commercial annuity with your 401k balance. The ability to payback and reapply for Social Security to gain a higher monthly benefit offers another (likely more cost-effective option) to buying a commercial annuity. Remember, too. that Social Security payments are indexed for inflation wheras most annuities are fixed dollar amounts.
4. Scenario 4: You took early Social Security benefits due to poor health. Your health has improved greatly and you now wish that you could revisit your decision. No problem. So long as you have assets to repay benefits already received, Social Security will give you a second chance.

Clearly, this is an extremely useful retirement planning tool to be aware of. Most major retirement decisions (e.g. lump sum vs annuity, beneficiary selection, etc.) are irrevocable. Getting a second crack at deciding when to take Social Security benefits opens many opportunities for creative and savvy retirees.

For further discussion of this topic see this excellent ESPlanner article.

This post is part of the latest Carnival of Personal Finance. Be sure to check out the other great entries as well.