How 'Chained CPI' Will Hit Your Pocketbook

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President Obama's new budget proposal includes changing a couple of key inflation calculations to something called a "chained CPI." The shift is getting a lot of attention right now because of the expected effect it will have on individuals.

There are two key places where a chained CPI -- short for consumer price index -- will have a direct impact on your pocketbook: income taxes and Social Security benefits. All else being equal, over time, your income taxes will be higher and your Social Security benefits will be lower than they are under current inflation calculations.

The key difference between the chained CPI and the traditional consumer price index is how the index measures consumer behavior. The chained CPI assumes that as prices rise on one product, some portion of consumers will be willing to substitute less expensive alternatives for what they used to buy.

That changes the product weightings used in the inflation calculation. By incorporating information from those new product weightings, the chained CPI typically produces a lower inflation level.

Here's how it works.

The Impact on Income Taxes

If you pay income taxes, your tax bracket is determined by the amount of taxable income you make. The cutoffs for each bracket generally rise over time with inflation.

The two charts below show the IRS "Schedule X" brackets for single taxpayers; the first is for 2012, and the second is what's currently expected for 2013:
IRS Chart
Chart for 2012 from the U.S. Internal Revenue Service
Chart for 2013 from the US Internal Revenue Service
Chart for 2013 from the U.S. Internal Revenue Service


While the 39.6 percent tax rate is new for 2013, note that the other brackets have higher cutoffs for 2013 than they did for 2012. That's thanks to the inflation adjustment made to the tax brackets.

If the law is changed so that the chained CPI is used, the tops of those brackets are expected to rise more slowly, exposing more of your income to higher tax rates than under current law.

The Effect on Social Security Benefits

Similarly, Social Security benefits are increased based on the inflation rate. By tying the payment increases to the chained CPI -- an inflation rate that grows more slowly than the current measure -- those benefit payments will grow less quickly as well. As a result, over time your Social Security checks will be smaller than they would have been under the old inflation calculation.

The annual changes aren't too extreme -- they're estimated to be somewhere in the vicinity of 0.1 percent to 0.3 percent per year, depending on what the future brings. But over time, it adds up to real money for those who pay income taxes or receive Social Security checks, with official estimates in the neighborhood of $340 billion in higher taxes and lower costs over the next 10 years.

Is It Better? Is It Fair?

To some extent, the chained CPI is more effective at measuring the behavior changes that we all make whenever possible to save some cash.

For example, if you've switched to generic medications whenever they're available, you're doing exactly what the chained CPI expects you to do. Likewise, if you started carpooling or taking the bus in response to higher gas prices, you're changing your behavior based on higher prices, just like the chained CPI projects.

On the flip side, of course, not all costs are easily switchable, especially for the seniors who rely on Social Security. For instance, health care costs have been rising faster than the overall inflation rate for decades, and older folks generally have higher health care costs than younger ones do. As a result, the change to a chained CPI will very likely make the gap between income growth and health care spending growth even more painful for seniors on Social Security.

The Big Picture

Still, if slowing the rate of benefit increases puts off the day of reckoning for when the Social Security Trust Fund runs out of cash and slashes benefits by around 25 percent, it may be worth it. That date is currently estimated to be a mere 20 years away -- well within the expected life span of most current workers and even some early retirees. To make it worse, if the CBO's recent release on Social Security is any indication, the next Social Security Trustees' Report may even pull that date even closer.

Given a choice between a slower rate of growth or a hard slash of 25 percent at some point in the not-too-distant future, neither option seems ideal. But still, a slower rate of growth is a lot less painful than waking up one day to find your sole source of income has shrunk by a quarter of its former value.

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How 'Chained CPI' Will Hit Your Pocketbook

Your age when you collect Social Security has a big impact on the amount of money you ultimately get from the program. The key age to know is your full retirement age. For people born between 1943 and 1954, full retirement age is 66. It gradually climbs toward 67 if your birthday falls between 1955 and 1959. For those born in 1960 or later, full retirement age is 67. You can collect Social Security as soon as you turn 62, but taking benefits before full retirement age results in a permanent reduction of as much as 25% of your benefit.

Besides avoiding a haircut, waiting until full retirement age to take benefits can open up a variety of claiming strategies for married couples. (More on those strategies later.) Age also comes into play with kids: Minor children of Social Security beneficiaries can be eligible for a benefit. Children up to age 18, or up to age 19 if they are full-time students who haven't graduated from high school, and disabled children older than 18 may be able to receive up to half of a parent's Social Security benefit.

To be eligible for Social Security benefits, you must earn at least 40 "credits." You can earn up to four credits a year, so it takes 10 years of work to qualify for Social Security. In 2012, you must earn $1,130 to get one Social Security work credit and $4,520 to get the maximum four credits for the year.

Your benefit is based on the 35 years in which you earned the most money. If you have fewer than 35 years of earnings, each year with no earnings will be factored in at zero. You can increase your benefit by replacing those zero years, say, by working longer, even if it's just part-time. But don't worry -- no low-earning year will replace a higher-earning year. The benefit isn't based on 35 consecutive years of work, but the highest-earning 35 years. So if you decide to phase into retirement by going part-time, you won't affect your benefit at all if you have 35 years of higher earnings. But if you make more money, your benefit will be adjusted upward, even if you are still working while taking your benefit.

There is a maximum benefit amount you can receive, though it depends on the age you retire. For someone at full retirement age in 2012, the maximum monthly benefit is $2,513. You can estimate your own benefit by using Social Security's online Retirement Estimator.

One of the most attractive features of Social Security benefits is that every year, the government adjusts the benefit for inflation. Known as a cost-of-living adjustment, or COLA, this inflation protection can help you keep up with rising living expenses during retirement. The COLA, which is automatic, is quite valuable; buying inflation protection on a private annuity can cost a pretty penny.

Because the COLA is calculated based on changes in a federal consumer price index, the size of the COLA depends largely on broad inflation levels determined by the government. For example, in 2009, beneficiaries received a generous COLA of 5.8%. But retirees learned a hard lesson in 2010 and 2011, when prices stagnated as a result of the recession. There was no COLA in either of those years. For 2012, the COLA came back at 3.6%. The COLA for the following year is announced in October.

Marriage brings couples an advantage when it comes to Social Security. Namely, one spouse can take what's called a spousal benefit, worth up to 50% of the other spouse's benefit. Put simply, if your benefit is worth $2,000 but your spouse's is only worth $500, your spouse can switch to a spousal benefit worth $1,000 -- bringing in $500 more in income per month.

The calculation changes, however, if benefits are claimed before full retirement age. If you claim your spousal benefit before your full retirement age, you won't get the full 50%. If you take your own benefit early and then later switch to a spousal benefit, your spousal benefit will still be reduced.

Note that you cannot apply for a spousal benefit until your spouse has applied for his or her own benefit.

If your spouse dies before you, you can take a so-called survivor benefit. If you are at full retirement age, that benefit is worth 100% of what your spouse was receiving at the time of his or her death (or 100% of what your spouse would have been eligible to receive if he or she hadn't yet taken benefits). A widow or widower can start taking a survivor benefit at age 60, but the benefit will be reduced because it's taken before full retirement age.

If you remarry before age 60, you cannot get a survivor benefit. But if you remarry after age 60, you may be eligible to receive a survivor benefit based on your former spouse's earnings record. Eligible children can also receive a survivor benefit, worth up to 75% of the deceased's benefit.

What if you were married, but your spouse is now an ex-spouse? Just because you're divorced doesn't mean you've lost the ability to get a benefit based on your former spouse's earnings record. You can still qualify to receive a benefit based on his or her record if you were married at least ten years and you are 62 or older.

Like a regular spousal benefit, you can get up to 50% of an ex-spouse's benefit -- less if you claim before full retirement age. And the beauty of it is that your ex never needs to know because you apply for the benefit directly through the Social Security Administration. Taking a benefit on your ex's record has no effect on his or her benefit or the benefit of your ex's new spouse. And unlike a regular spousal benefit, if your ex qualifies for benefits but has yet to apply, you can still take a benefit on the ex's record if you have been divorced for at least two years.

Note: Ex-spouses can also take a survivor benefit if their ex has died first, and like any survivor benefit, it will be worth 100% of what the ex-spouse received. If you remarry after age 60, you will still be eligible for the survivor benefit.

Once you hit full retirement age, you can choose to wait to take your benefit. There's a big bonus to delaying your claim -- your benefit will grow by 8% a year up until age 70. Any cost-of-living adjustments will be included, too, so you don't forgo those by waiting.

While a spousal benefit doesn't include delayed retirement credits, the survivor benefit does. By waiting to take his benefit, a high-earning husband, for example, can ensure that his low-earning wife will receive a much higher benefit in the event he dies before her. That extra 32% of income could make a big difference for a widow who has lost her husband's stream of Social Security income.

One option for a spouse who is delaying his benefit but still wants to bring some Social Security income into the household is to restrict his application to a spousal benefit only. To use this strategy, the spouse restricting his or her application must be at full retirement age. So the lower-earning spouse, say the wife, applies for benefits on her own record. The husband then applies for a spousal benefit only, and he receives half of his wife's benefit while his own benefit continues to grow. When he's 70, he can switch to his own, higher benefit. Exes at full retirement age can use the same strategy -- they can apply to restrict their application to a spousal benefit and let their own benefit grow.

Here's a Social Security claiming strategy that's perfectly legal and potentially lucrative. Let's say a husband decides he wants to delay taking his benefit until age 70 to maximize the amount of his monthly check. But he wants his wife to be able to take a spousal benefit, because it would be higher than her own benefit.

To make that happen, the husband, who must be at full retirement age, can file for his benefits and then immediately suspend them. Because he has applied for benefits, his wife can now take a spousal benefit based on his record. And because he suspended his own benefit, his benefit will earn delayed retirement credits for each year he waits until age 70.

Most people know that you pay tax into the Social Security Trust Fund, but did you know that you may also have to pay tax on your Social Security benefits once you start receiving them? Benefits lost their tax-free status in 1984, and the income thresholds for triggering tax on benefits haven't been increased since then.

As a result, it doesn't take a lot of income for your benefits to be pinched by Uncle Sam. For example, a married couple with a combined income of more than $32,000 may have to pay income tax on up to 50% of their benefits. Higher earners may have to pay income tax on up to 85% of their benefits.

Bringing in too much money can cost you if you take Social Security benefits early while you are still working. With what is commonly known as the earnings test, you will forfeit $1 in benefits for every $2 you make over the earnings limit, which in 2012 is $14,640. Once you are past full retirement age, the earnings test disappears and you can make as much money as you want with no impact on benefits.

But the good news is that any benefits forfeited because earnings exceed the limits are not lost forever. At full retirement age, the Social Security Administration will refigure your benefits going forward to take into account benefits lost to the test. For example, if you claim benefits at 62 and over the next four years lose one full year of benefits to the earnings test, at age 66 your benefits will be recomputed -- and increased -- as if you had taken benefits three years early, instead of four. That basically means the lifetime reduction in benefits will be 20% rather than 25%.

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