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Social Security benefits can be reduced two ways if you retire early

Q: Would you please explain to me how Social Security works when a person is drawing benefits and still working?

A: Between age 62, the earliest age at which you can claim Social Security benefits, and your full retirement age (FRA), your benefits can be reduced if your wages exceed a certain amount, $15,120 this year. Above that amount, Social Security will deduct $1 for every $2 you earn.

You get a break in the year you reach your full retirement age. In that year, Social Security deducts only $1 for every $3 you earn up until the month before you reach full retirement age. There is no limit on what you earn once you reach full retirement age. For those born between 1943 and 1954, the full retirement age is 66. This applies only to wage income. It does not apply to income from dividends, interest, rents and capital gains.

Many people get this reduction of benefits for earned income confused with another thing that is affecting retirees — the taxation of Social Security benefits. While the reduction of benefits occurs if you earn too much between age 62 and FRA, your benefits can be subject to taxation at any age. How much you pay in taxes on your benefits depends on your income from other sources, including wages, dividends, interest, capital gains and rents.

Information about this is on the Social Security website starting at this page: ssa.gov/retire2/whileworking.htm

Q: I am trying to build an income stream. Are the Vanguard funds with these tickers, VPGDX and VPDFX, good investment choices? Are utility stocks a better investment for this purpose?

A: The funds you have asked about are “managed payout” funds, a relatively new type of fund introduced as the financial crisis was beginning. Those offered by Vanguard and Schwab are managed to make payments indefinitely, while Fidelity offers funds designed to terminate at a particular date. What the funds actually pay out will depend on future performance, so you should not think that your income will remain stable — it can go down in a bad market.

Vanguard Managed Payout Growth and Distribution (ticker: VPGDX) targets a 5 percent distribution. Vanguard Managed Payout Distribution Focus (ticker: VPDFX) targets a 7 percent distribution rate. What you need to be very conscious of is that what the fund distributes has virtually no relationship to the actual income yield of the underlying fund portfolio. The recent current yield on the Growth and Distribution fund, for instance, was 1.88 percent, while the yield on the Managed Payout Distribution Focus was 1.79 percent. The difference will come out of your principal.

The question is whether the fund will provide enough return — at least 5 percent or 7 percent — to sustain its original value. If it doesn’t, the value of your investment will shrink over time. In a sense, you have opted to take life annuity-like income without having the assurance that the distributions can be sustained. Recent research indicates that it is likely that such portfolios will not be able to sustain that distribution rate.

This is not due to any management failure at Vanguard, Schwab or Fidelity. The problem begins with the incredibly low yields on fixed-income investments and equities. While historical studies have long supported the idea that you could withdraw at a 4 percent rate (and sometimes more) from a retirement portfolio and not run out of money in a 30-year retirement, more recent research that is grounded in current yields suggests a much higher failure rate.

How high? Try this: The June issue of the Journal of Financial Planning contains an article which projects that a portfolio with a construction similar to that of Vanguard Managed Payout Growth and Distribution will have a 68 percent failure rate with a 5 percent initial payout. The payout on the actual fund will vary, of course, so that figure doesn’t apply, but this should give you some idea of the risk involved in looking for such high distribution rates.

Building a 100 percent utilities portfolio isn’t a solution, either. If you check electric utility yields, you’ll find that most are less than 5 percent.



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