Working Past 65? Don't Overlook the Financial Side Effects

Working past the traditional retirement age of 65 is the fallback strategy for many people hurtling toward retirement but concerned they haven't saved enough. And indeed, the financial benefits of deferring retirement can be potent. Continuing to work means continuing to save, for one thing, and even more important, deferring withdrawals from your investment kitty also reduces the number of years you'll need your investments to last. Working longer also often means deferring Social Security, which itself delivers a sizable inflation-adjusted compounding benefit.

But continuing to work past the traditional retirement age--or even part time during retirement--can bring unintended financial side effects, some good, some bad. These issues should, of course, play second fiddle to the key factors surrounding whether to continue to work: whether you want to, whether you're able to, and whether continuing to earn a paycheck will have a meaningful effect on your bottom line. That said, here are some of the secondary financial issues to bear in mind as you assess the merits of working past 65.

Social Security Benefits
First, the good news. If you've waited until your full retirement age or later to file for Social Security benefits, you can earn as much income as you like and not see your Social Security benefit reduced by a dime. However, if you've claimed benefits prior to your full retirement age (currently 66, rising to 67 for younger baby boomers), you'll be hit with a penalty on earnings that exceed $14,640 (in 2012) until you hit your full retirement age. For every $2 that your wages are over that limit, your Social Security benefit will be reduced by $1. In the year you reach your full retirement age, you can earn up to $38,880 without a benefit reduction; once your earnings exceed that threshold, your benefits will be reduced by $1 for every $3 over that amount until the month you hit your full retirement age. This calculator helps estimate the extent to which working will reduce your Social Security income if you claim benefits before your full retirement age.

On the plus side, those withheld benefits aren't lost forever: When workers hit full retirement age, their benefits are recalculated and the withheld benefits are essentially added back into their Social Security benefits. But as Morningstar columnist Mark Miller notes in this article, those reductions--and the fact that they kick in at fairly modest income levels--are a key reason why those who are still working should defer Social Security until their full retirement age if they can swing it.

Social Security Taxation
Even if you're past full retirement age, it's worth noting that Social Security benefits become taxable once your income exceeds a certain threshold. That means that continuing to work is apt to increase the taxes you'll owe on your benefits. In fact, for the highest-income people, Social Security benefits can be up to 85% taxable.

For the purpose of what's taxable under the Social Security calculation, income includes all of the usual items that compose adjusted gross income on your tax return, including wages and investment income; income taxable under Social Security also includes nontaxable investment income (yep, municipal-bond income) and one half of your Social Security benefits. That total is called your provisional income. If provisional income is lower than $25,000 for singles and $32,000 for married couples, the Social Security benefits are tax-free. If provisional income is between $25,000 and $34,000 for singles and between $32,000 and $44,000 for married couples, the Social Security benefit is up to 50% taxable. If provisional income is above the highest thresholds--$34,000 for singles and $44,000 for married couples--up to 85% of your Social Security benefits become taxable.

Given those fairly low dollar amounts, it's easy to see how even a modest sum of wage income could bump your provisional income into one of the higher thresholds. And once the effects of those higher tax costs on your Social Security benefits are factored in, continuing to work might not be as beneficial as it seemed at first blush. At the same time, someone who wanted to continue working longer could simply delay receipt of Social Security, thereby avoiding the aforementioned benefit reductions and tax implications. Alternatively, the variety of income sources that factor into provisional income means that even people who continue to earn a salary while also receiving Social Security benefits have some latitude to reduce the tax hit. For example, someone who wanted to continue working while limiting taxation of their Social Security income might benefit from converting traditional IRA and 401(k) assets to Roth in the years prior to receiving Social Security (thereby enabling tax-free withdrawals from their IRAs) and focusing on growth (that is, non-income-producing) investments for taxable accounts.

IRA/401(k) Contributions
One of the chief benefits of continuing to earn a salary past the traditional retirement age is that you can continue to make retirement-plan contributions, at least to some account types. If you're employed and your company offers a 401(k) plan, for example, you'll be able to make contributions to it regardless of your age. And while traditional IRA contributions are off-limits once you've reached age 70 1/2, you can make Roth IRA contributions regardless of your age, provided you have enough earned income to cover the contribution and your modified adjusted gross income doesn't exceed $125,000 in 2012 (single filers) or $183,000 for married couples filing jointly. Even if just one spouse is working, he or she can make Roth IRA contributions for both spouses, provided the working spouse's income is equal to or higher than the total amount contributed. 

Roths--whether Roth IRAs or Roth 401(k)s--will be more attractive for pre-retirees who expect to be in a higher tax bracket when they eventually retire than they were when they made the contribution and/or for those who would like to avoid having to take required minimum distributions once they turn age 70 1/2. (People with Roth 401(k)s are required to take RMDs from them, but such individuals can readily roll their money into a Roth IRA, thereby circumventing RMDs.)

401(k) RMDs
In a related vein, being an active worker can also help you delay RMDs from a 401(k) plan, even if you've passed age 70 1/2. Assuming your 401(k) plan rules allow it, you can defer withdrawals from the plan until you actually retire. A key exception is if you own more than 5% of the company; in that instance, RMD rules still apply, even if you're still working. Note that this exception to RMDs only applies to 401(k)s; RMDs from traditional IRAs are mandatory whether you're working or not.

Health-Care Coverage
People who continue working past age 65 will also have some decisions to make on the health-care front because they might be covered by a health-care plan at work while also eligible for Medicare coverage.

In most cases, the best option will be to sign up for Medicare Part A even if you're staying on your company's health-care plan. (If you're receiving Social Security, you'll automatically be signed up for Medicare Part A and B coverage just before you turn 65.) As Mark Miller outlined in this article, you won't pay any premium for the Medicare Part A coverage, and you'll avoid having to jump through hoops to enroll when you actually do retire. Your employer's health-care plan will continue to be your primary insurer if you work for a company with more than 20 employees; if there are fewer than 20, Medicare will be your primary insurer.

This strategy might not be for everyone, however, especially if you're actively funding a health savings account. In that case you'll no longer be able to contribute to the HSA once you've signed up for Medicare benefits or you've been automatically opted in. If contributing to the HSA is a valuable component of being employed, it might be worth it to hold off on Medicare Part A. (Just be sure to notify Medicare of your decision, as outlined in this article.)

You can also probably delay enrolling in Medicare Part B if you're covered by a company health-care plan, relying on your company's insurance instead. Larger companies are required by law to provide older workers with the same health-insurance benefits as younger ones, but if you work for a small company (fewer than 20 employees), your employer may require you to sign up for Medicare Part B at age 65. When you do sign up for Medicare Part B, be sure to follow the rules to ensure that there's no break in coverage and that you won't pay extra premiums that other people who delay Part B coverage will pay. This Q&A provides the details.

You should also consider signing up for Medicare Part D as soon as you become eligible if your company's plan doesn't include coverage for prescription drugs. In this case, you'll pay a premium for the coverage, but it could be well worth it if you have substantial pharmacy costs. However, be sure to enroll within three months after your 65th birthday; if you sign up after this window, you will incur a penalty. 

If your company does offer drug coverage and it's creditable (that is, it's at least as good as what's available under Medicare Part D), you'll be able to avoid the penalty if you sign up for Part D at a later date. Page 46 of this document provides more detail on creditable prescription drug coverage; check with your plan administrator to find out whether your current plan is creditable. If your employer's drug coverage is not creditable, you must enroll in Medicare Part D no later than three months after you turn 65 to avoid the penalty.

Last but not least, people who are still working should pay attention to the high-income premium surcharges for Medicare Parts B and D, which affect individuals with $85,000 or more in taxable income and married couples filing jointly with taxable incomes of more than $170,000. (You can read some of the details here.) Those thresholds are high enough that tax-management techniques such as converting traditional IRA assets to Roth prior to retirement might help circumvent the surcharge.

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