The rise of the early retirement movement may leave US nationals and permanent residents blindsided regarding the effects of early retirement on Social Security benefits. Working abroad has similar effects for US nationals’ Social Security entitlements, as most US nationals do not pay FICA tax while abroad. The taxes you pay over the Foreign Earned Income Exclusion do not include FICA.
Social Security is an annuity from the United States government that is granted monthly after one files for such when they have reached retirement age (67 is Full Retirement Age for most nationals, though you can begin claiming at 62 for reduced payments, or delay claiming to increase your payments). It is also a tremendously valuable asset. It lasts as long as you do (for the rest of your life). Social Security cannot be passed onto heirs (although a spouse can collect your Social Security when you die, if your payout was larger). Social Security is a better deal than a commercially available annuity, considering its relatively low cost and high return for most income earners. Social Security is a guaranteed income. This income is very similar to owning a government bond. So, it should be viewed as an asset located in the government bond sector of your asset allocation. This should be kept in mind when creating any asset allocation models. See Kitces article for further explanation on this subject.
Social Security payments are most valuable because they are assets different than the others in your nest egg. It cannot be taken by private creditors. If you lose one month’s payment at Vegas, another payment will come next month. A meddling child cannot con the entitlement away from you (at least not all at once). This structural difference is what makes Social Security an essential part of a retirement plan.
Furthermore, the amount in Social Security payments is not shabby. Payments generally range from $1,500 - $3,830 per person per month. If you are a working married couple, and you retire at Full Retirement Age and live to the current average life expectancies, you should expect approximately $1.5 Million in Social Security benefits in your golden years, if you paid 35 years of the maximum amount of FICA taxes during your working years. That would be helpful to have. And while one may argue you cannot retire on that amount in a western country (I would agree with you), you should aim for this asset to support approximately 1/3 of your retirement.
How Social Security Accrues
US nationals and permanent residents who work and pay FICA taxes are contributing to their Social Security. Social Security accrues on a credits basis, and one must accrue 40 credits in order to claim Social Security. In 2019, it takes $1,360 in earnings to earn 1 credit, and you can earn up to 4 credits per year. So, normally it takes 10 years to accrue enough credits to collect social security. The same number of paid credits (40) is applicable for collecting Medicare benefits.
How Your Social Security Payments are Calculated
Simply put, Social Security is an adjusted average of 35 years of earnings in the United States.
Once your earnings are indexed, these are averaged out to determine a monthly average. This is called your Averaged Indexed Monthly Earnings (AIME). While I will explain how AIME is calculated, I do not recommend you attempt to do so for yourself, as I will explain later.
AIME is calculated as follows:
1. Add the highest 35 years of indexed earnings.
Although only 10 years (or 40 credits) are needed to be entitled to Social Security, AIME is calculated based on your highest 35 earning years. Earnings are “indexed”, or adjusted for wage growth, to the year you turn 60. This means the earlier years are given greater credit as time goes by.
If you only worked 10 years, you would add your indexed earnings of these 10 years together, and effectively add 25 zeros into this total. Persons who retired early, worked abroad (without paying FICA), or stayed home with children would not accrue monetary benefits, as they were not adding to their Social Security credits.
2. Divide total by 420 (the number of months in 35 years).
3. The result is your AIME.
Primary Insurance Amount
AIME is used to calculate one’s Primary Insurance Amount (PIA). Your PIA is how much you will draw monthly from your Social Security entitlement if you begin at your Full Retirement Age. While the dollar figures in this calculation change, the current equation for PIA is:
§ 90% of any AIME up to $926, plus
§ 32% of any AIME between $926 and $5,583, plus
§ 15% of any AIME above $5,583.
This calculation reflects the aim of Social Security to both create an adjusted average of your earnings and generally redistribute wealth.
Instead of crunching the numbers yourself, go to ssa.gov and create your own login. The government has your earnings history waiting for you, and you can readily see your full history and get a full statement from SSA about your personal situation. If you want to double-check your PIA calculation, another favorite social security calculator is available at Social Security Tools.
At this point you have an idea of what your Social Security entitlement is. If you want it to be higher, read on.
Working Abroad: Pay FICA!
Although this article primarily discusses the effects of working abroad on US nationals' or permanent residents' Social Security entitlement, early retirees, who are not contributing to FICA, may likewise benefit from the advice herein. Surely, no one wants to create a means to pay seemingly unnecessary taxes. US nationals are not required to pay FICA while abroad. However, it is worth it to do so, as (1) you accrue credits, allowing you to fulfill Social Security and Medicare (also 40 credits, and allows you to have subsidized health care in your otherwise medically expensive old age) requirements, if you have not already; and (2) you boost your AIME, thus, your PIA (so your payments that you will someday receive will be worth more).
The most ready way to do this from abroad is to get a side hustle as a private contractor in the United States. As a contractor, you are required to pay 12.5% (15.3% including Medicare) of your income into FICA (as an employee, your employer would pay half of this, so 6.25%). These side hustles become more and more easy to land, as companies endlessly move towards remote working (which is, after all, a cheap benefit to offer). It is ideal to earn enough per annum to acquire the full 4 credits for the year (which, in 2019, is $5,440). The obvious benefit in this is that allows the 40 credits to accrue quicker.
Don’t think it’s worth it to opt into FICA? Check out this case study.
Case Study: Abu Dhabi Anna, AKA Why FICA Wins
Anna’s case: Anna, a US national, works in the UAE for her entire career, claiming the Foreign Earned Income Exclusion. However, she works remotely, editing articles for an online newspaper based in Washington, DC, from 2010 - 2019. Each year, she earns $6,000 in income, as a private contractor.
Here are two routes Anna could take with her US-earned income:
1. Report it. Anna reports $6,000 in her tax filing, as US-earned income. She is exempt from paying federal income tax, and so only pays FICA tax at 15.3% ($918). She thus pays only $918 in taxes, and retains $5,082 which she invests in a diversified index fund, in a Roth IRA, with a 7% ROI. As the Roth IRA limits for 2010 - 2012 were $5,000 for persons of her age, she invests the $5,000 in her Roth for those years, and invests the remaining $82 for 2010 - 2012 in a taxable index fund.
2. Invest it all. Anna, unlawfully, does not report her $6,000 earned income. She does not pay any federal income or FICA tax, and places all income, each year, in a diversified index fund, with a 7% ROI.
Anna retires at full retirement age in 2053. Her two possible retirement scenarios, based on the two routes discussed above, are as follows:
1. Reported it. Anna reported her contractor earnings. She now takes home $477 monthly in retirement benefits, and receives free Premium A[1]Medicare coverage. If she lives until 81, as she can currently expect as a woman who is a US national, she will receive approximately $105,006 in Social Security coverage during her remaining lifetime. She will not pay taxes on this income.
This amount, of course, is considerably low, as Anna had very little US income, and so this amount is not reflective of the Social Security payout most US nationals will receive.
Anna also invested her contractor earnings, after she paid FICA. If she withdraws this when she retires, she will have accrued $792,238 from the compound interest in her Roth and her index fund, and will not have to pay any capital gains tax, as this was in a Roth and the accrual from the the index fund ($4,125) would not be taxable if withdrawn at once, due to the standard deduction. With the Social Security payments, she will have $897,244 and premium-free Part A Medicare, just from her contractor income.
2. Invested it all. Anna did not report any of her contractor earnings, and did not pay FICA. She placed all her annual $6,00 earnings in her diversified index fund, where it stayed. When she looks at this investment in 2053, she has $1,002,845. If she withdraws this when she retires, she will pay a capital gains tax up to 20%. She will then have $802,276. Furthermore, Anna now pays $1,012 monthly in Medicare premium (reflective of how much she would pay today, adjusted for inflation). For the remainder of her life, Anna will pay $222,780 in Part A Medicare premiums. Anna thus ultimately has $579,496 income available for retirement from her contactor income, considering her Medicare payments.
This scenario also assumes Anna did not lose her investment in a debt suit, get divorced, or decide to raid her investment. These are generous assumptions.
This scenario assumes Anna withdraws her investments at 67. If she instead withdraws a moderate income stream, and retains her investments, her greater growth in her Roth would become more pronounced. Furthermore, the longer that Anna lives, the greater the benefits of her Social Security and Medicare contributions would become.
Your Social Security Entitlement
Everyone’s personal situation is different, and so if you want to be sure FICA is worth some sweat, I recommend checking out your own entitlement, and what would happen if you did not pay FICA. Check out the SSA calculators to see how much your PIA would be worth if you had zeros for years in which you planned on working outside the United States.
Now plug in the amounts of earnings on which you would pay FICA if you had a side hustle which yielded SSA credits ($1,360 for one credit and $5,440 for four credits in 2019) into the SSA benefits calculator.
Assume you would put any amounts you paid into taxes into an index fund yielding 7% if you did not have to pay such tax.
Now plug the FICA tax + Fed income tax that you would pay (which is probably $0 due to standard tax deduction) on the side hustle into MoneyChimp’s Compound Interest Calculator, with a plan to withdraw at retirement age. Remember to subtract capital gains tax.
Numbers aside, SSA entitlement should be celebrated as it is an asset which offers structural benefits over, say, the cash you withdraw from an index fund. It is yours until you die.
FICA-Friendly Side Hustle
US nationals can readily cook up a "side hustle" and invest in Social Security and Medicare. Side hustles, or secondary active income sources, are already widely promoted as a key to financial independence. For a US national or permanent resident abroad, however, these have the additional benefit of accruing credits. Developing a side hustle is easier than it seems and can be quite fun and lucrative. Consider some options.
Former Employer Remote Side Hustle
The first place to look may be a prior employer, if you have one, in the United States. You are necessarily at an advantage when you approach a former employer, as you know how to do your job. If you offer remote contract work to your employer, you are offering labor without the employer having to pay any benefits, or FICA tax. This is a win-win for everyone, and when you report it at the end of the year, you have made an investment in your future.
Google “Remote Job”
It really is that simple. If you Google “remote job”, “work from home”, or otherwise indicate in your search of a job board that you are interested in remote work, a barrage of options come up. Some sites even specialize in these work from home options.
Personal Side Hustle
There may be something you can provide for a family member or friend, based on your skills. Tutoring? Website development? Roofing work on Uncle Jack’s garage for the two weeks you are home in July? As a contractor, your client can be anyone, including a private individual. And this work is all taxable. Yes, that babysitting work you did under the table as a teenager was taxable (though the IRS did not care enough to audit you over it). Had you actually paid taxes on babysitting your neighbor’s two-year-old that summer, your PIA would be higher.
Bottom line: Paying FICA should not be difficult, as there are many options, and the IRS is more than happy for you to report that you owe them $.
In Short
I hope I can encourage those US nationals and permanent residents outside the US, and/or retiring early, to not neglect accrual of Social Security and Medicare. Social Security is responsible for depleting elderly poverty. Even your broke friends, who worked their whole lives and never saved a brass penny, but paid their FICA taxes, have Social Security payment waiting for them when they retire.
Numerous resources exist on Social Security. I would encourage everyone to sign up to SSA.gov to check out your current entitlements (make sure the calculator is clear how much you anticipate making the future, as it will assume this amount based on your projected earnings this year).
I also encourage anyone interested in learning more about Social Security to read further at Oblivious Investor’s Open Social Security.
If you do not invest in FICA, and allow zeros to accrue in your years reported for your AIME, be aware of this shortfall, and plan to fund your retirement, and if necessary, your healthcare, accordingly.
[1]Medicare itself does not cover the entirety of medical costs. Furthermore, Medicare encompasses Medicare Parts A, B, C, D.