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James Sullivan
James Sullivan
 

The Windfall Elimination Provision

How it can reduce Social Security benefits substantially.

January 21, 2010
by James Sullivan, CPA, PFS

This article was previously published in the CPA Insider™ e-newsletter.

The Windfall Elimination Provision (WEP) reduces the monthly Social Security benefit received by certain participants such as teachers and local government employees. This reduction can be substantial and is often unexpected. Participants impacted by this law (eventually, almost 10% of all Social Security recipients) often overestimate their retirement income by not taking the reduction into account. CPA, PFS advisors can provide a valuable service by understanding and explaining the rules to their clients. Knowledge of these rules can also help advisors grow their practice. This article provides a general overview of the rules.

What Is the WEP?

The best way to understand the WEP is to first understand the Social Security benefit formula. The formula is designed to provide a disproportionately higher benefit to lower income workers. This is done using a three tiered benefit formula that accrues Social Security benefits at 90 percent; 32 percent and 15 percent. These rates are applied to the average earnings of all taxpayers. But higher income taxpayers see their benefit rate decrease from 90 percent to as low as 15 percent as their average earnings increase.

Proponents of the WEP argue that the high (90%) benefit rate applied to lower earnings is designed for individuals who were lifelong low income earners. It was not designed for otherwise middle income earners (such as teachers) who spent most of their working lives earning wages outside the Social Security system. The low threshold for earning a monthly Social Security benefit is easily attainable and the 90-percent benefit rate can represent a “windfall” for middle-income workers.

To eliminate this “windfall” Congress passed the WEP to reduce the 90-percent benefit rate to as low as 40 percent for certain Social Security beneficiaries. The 32-percent and 15-percent benefit rates are not impacted. As discussed below, the WEP reduction can be avoided in whole or in part if the worker had “substantial earnings” covered by Social Security. Before discussing the “substantial earnings” escape hatch requirements, let’s look at the Social Security benefit calculation in more detail.

The first step in computing a worker’s monthly benefit is computing his or her Average Indexed Monthly Earnings (or AIME) over his or her working life. Only wages covered by Social Security are included in the calculation of the AIME. The AIME is roughly the worker’s average monthly earnings covered by Social Security over their working life adjusted for inflation. Once the AIME is computed the actual monthly Social Security benefit is determined.

The 90-percent, 32-percent and 15-percent benefit rates are applied at dollar amounts referred to as “bend points.” In 2010, the benefit rates are applied to the following dollar amounts:

Benefit (%)
Bend Points
90 percent
AIME up to $761
32 percent
AIME over $761 through $4,586
15 percent
AIME over $4,586

If a worker has AIME of $761 or less, they will receive a monthly Social Security benefit equivalent to 90 percent of that amount. With an AIME of $761, the monthly benefit will be approximately $685 (90% x $761).

The monthly Social Security benefit of a higher income earner with AIME of $4,000 would be $1,721 calculated as:

AIME
Benefit (%)
Monthly Social Security Benefit
Up to $761
90 percent
$685
Over $761 up through $4,586
32 percent
$1,036*
Total
$1,721

(* $4,000 minus $761 times 32 percent equals $1,036)

Note that the lower-income worker will receive a higher monthly benefit from Social Security as a percentage of their AIME than the higher-income worker. The lower-income worker receives 90 percent of their AIME ($685 ÷ $761) while the higher income worker receives 43 percent ($1,721 ÷ $4,000).

The WEP reduction is calculated by reducing the 90-percent benefit rate to as low as 40 percent for certain participants.

Impact on Retirement Planning

While a client may know he or she is subject to the WEP, they may have little or no idea how much the potential reduction may be.

Let’s redo the benefit computed above for the worker with AIME of $4,000 assuming they are subject to the maximum WEP reduction:

AIME                
Benefit (%) Before WEP Reduction
Monthly Benefit Before WEP Reduction
Benefit (%) After WEP Reduction
Monthly Benefit After WEP Reduction
Up to $761
90 percent
$685
40 percent
$304
Over $761 up through $4,586
32 percent
$1,036
32 percent
$1,036
Total Monthly Social Security Benefit
$1,721
$1,340

Note that the WEP reduction only impacts the 90-percent benefit percentage reducing it to 40 percent. The 32-percent and the 15-percent benefit percentages are not reduced. The total monthly reduction due to the WEP in our example is $381 ($1,721 – $1,341).
 
Unfortunately, the client’s annual Social Security statement provides only a general statement regarding the WEP. The Social Security monthly benefit shown on the statement is not reduced for the WEP. This means that the client will be overestimating their monthly Social Security benefit if the proper adjustment is not made.

The WEP reduction cannot exceed one-half of the participant’s pension from non-Social Security covered employment. In our example above, if the participant’s monthly government benefit pension is $500, the WEP reduction cannot exceed $250 or one-half of $500.

Substantial Earnings Can Lessen Impact of WEP

The actual reduction faced by your client will depend on how many years of “substantial earnings” they have of covered Social Security wages. In other words, if your client had 30 years or more of substantial earnings covered by Social Security, they are considered to have contributed sufficiently to the Social Security system to earn the full 90-percent benefit rate at the first bend point. In 2009, substantial covered earnings was defined as $19,800 or more. The 90-percent benefit rate is reduced by five percentage points for every year of substantial earnings less than 30.

Returning to the above example, if the worker with AIME of $4,000 had 24 years of substantial earnings, their benefit after the WEP reduction would increase to $1,493 from $1,340 due to the benefit percentage increasing from 40 percent to 60 percent:

AIME                 
Benefit (%) Before WEP Reduction
Monthly Benefit Before WEP Reduction
Benefit (%) After WEP Reduction With 24 Years of Substantial Earnings
Monthly Benefit After WEP Reduction
Up to $761
40 percent
$304
60 percent
$547
Over $761 up through $4,586
32 percent
$1,036
32 percent
$1,036
Total Monthly Social Security Benefit
$1,340
$1,493

The benefit rate at the first bend point is never less than 40 percent. A client with five years of substantial earnings will be treated the same as a client with 20 years of substantial earnings. Both will have a benefit rate of 40 percent at the first bend point.

For more information on WEP, see SSA Publication No. 05-10045. Exceptions apply to certain workers depending on factors such as employment dates. The WEP reduction can be estimated by going to www.socialsecurity.gov/gpo-wep.

Conclusion

The economic events of the last 18 months have increased the interest among baby boomers in their Social Security benefits. Advisors have an opportunity to grow their practice and provide additional value to their clients by mastering the Social Security rules.

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James Sullivan, CPA, PFS, MAS, is an investment counselor at Core Capital Solutions LLC. He has almost 25 years of experience in individual tax, investing and personal financial planning. Before joining Core Capital Solutions, Sullivan spent 20 years at Arthur Andersen LLP. He is a member of the AICPA PrimePlus/ElderCare Task Force.