Sometimes, as a financial planner, I have to deliver bad news.
“We may have to look at cheaper homes.”
“Sure, you can retire this year, but you may have to sell the boat.”
“No, you can’t buy lotto tickets in your Roth IRA.”
The other day was no exception. A client came into the office, having finally collected his U.S. and Canadian retirement benefit information. He worked and lived in Canada for 15 years, before coming here to the U.S. and working the past 18. He is planning on retiring next year, and was feeling pretty good after seeing his U.S. social security, Canadian Pension Plan (CPP) and Old Age Security (OAS) estimates. By his calculation, he would receive $1,800 from social security, $850 from CPP and $250 from OAS each month. He figured a cool $2,900 coming in each month from the U.S. and Canadian government combined. Then I had to deliver the bad news. The Windfall Elimination Provision (WEP) is going to wipe out about $400 from his social security calculation. I hardly had the heart to tell him that he is also probably going to lose out on the OAS benefit as well (more about that here). This post addresses how WEP may impact your social security benefit if you have a CPP.
What is WEP and when does it apply?
Most of us have to never worry or deal with WEP. If you have only worked in the U.S. and paid social security taxes on your income, you probably won’t have a WEP reduction. WEP is applied when you have earned a pension while not paying social security taxes on the income. This tends to happen in two occasions:
- You worked for a state or nonprofit organization that provides a social security equivalent pension, but you don’t make social security payments
- You worked in another country in which the country or the private company you worked for provides a pension.
The second example is what I tend to run into the most. For example, maybe you spent some of your working career in Canada. While in Canada you earned Canada’s equivalent to social security, CPP. The pension you earned in Canada now impacts your U.S. social security through WEP. Some states, like Ohio state workers, may not contribute to social security, as they have set up their own form of social security. This pension benefit would also impact your social security benefit through WEP.
What is the reason for WEP?
It may not seem fair that just because you worked somewhere in which you earned a pension and didn’t pay into social security, your social security gets cut. Still, there is actually an explanation for WEP. Social security is meant to replace a certain amount of your pre-retirement income. Also, social security is based on your total lifetime earnings. For people who have earned less during their working career, social security replaces a higher percentage of your pre-retirement income. In order to do this, lower income earners actually get a little boost to their social security benefit. Social security assumes that they are taking into account all of your earnings. Social security can’t account for years in which you worked and paid into a pension, but not social security. Therefore, WEP is meant to eliminate this “boost” that you get that should only be eligible for lower income earners. WEP may not seem fair, but there is a reasonable explanation.
How is your social security benefit calculated?
I’m not going to get into the exact math on how your social security benefit gets calculated. The formula is complex and it’s a waste of time to do the math on your own when there is a quick online calculator in which you can get an estimate quickly here. Here are some of the basics of how your social security benefit is calculated. The more that you earn over your working career, the higher your social security benefit. Also, social security is based on the highest 35 years of your working career. Back in the day social security used to send an annual statement with your estimated benefit. A few years back, in order to save money, they stopped sending out the statement. However, the simple calculator will help you determine your social security benefit at different ages.
How does WEP affect your social security benefit?
If you are collecting a pension from a country or a company/state/city in which you didn’t pay social security taxes, you may have a WEP reduction. The amount of the WEP reduction is based on 2 things:
- The value of your uncovered pension
- The number of years that you worked and had substantial earnings
Below is the WEP reduction table for 2018. The vertical number is the number of years that you had “substantial” earnings and made social security payments. The number next to that is the maximum WEP reduction.
|Years working in the U.S.||Maximum WEP Reduction|
|Less than 20||$448|
|More than 30||$0|
Source: Social Security
A few notes about the WEP reduction:
- The WEP reduction is the lesser of the WEP reduction number above or ½ of your pension benefit
- If you have a foreign pension, the WEP reduction amount is subject to foreign exchange rates
- A surviving spousal benefit is not subject to a WEP reduction
- If you have more than 30 years of substantial earnings here in the U.S., you will have no WEP reduction
- The maximum WEP reduction is $448, but only applies if you have less than 20 years of substantial earnings
- Below is the earnings that you need to exceed each year in order to have “substantial earnings”
Source: Social Security
Delaying or starting social security early and WEP
I am not going to go too much into the basics of social security. However, you probably already know that you can start social security as early as age 62 and can delay to as late as age 70. The government has decided that your full retirement age (FRA) is somewhere between age 66 and 67, depending on when you were born. The WEP reduction table above assumes that you start your social security at your FRA. If you start your social security benefit early, you will have a smaller WEP reduction. If you delay social security, you will get a higher WEP reduction. For example, if your FRA is age 66, you will get 75% of your full benefit if you start at age 62. This is the same amount that your WEP is reduced. For example, let’s say that you have less than 20 years of substantial earnings and are subject to the maximum $448 WEP reduction. If you start social security at age 62, you will have only a $336 WEP reduction. Of course, by starting social security early, you will also have a smaller social security benefit.
Each year that you delay social security past your FRA, you get an 8% increase in your social security benefit. You also get an 8% increase each year in the WEP. If you delay until age 70, you will have a 32% increase to the WEP benefit. Therefore, instead of having a $448 WEP reduction, you will have a $591 reduction to social security.
Here’s an example of social security benefits after 2018 WEP reduction, assuming 66 is the FRA and the maximum WEP reduction.
|Age||Social Security||WEP Reduction||S.S. Benefit after WEP|
Social security WEP reduction and COLA
Social Security has a cost of living adjustment (COLA) which increases your benefit to keep up with inflation. Unfortunately, if you have a WEP reduction, you get the short end of the stick here. Instead of increasing your social security benefit prior to the WEP reduction, they increase your smaller amount after the WEP reduction benefit. In 2019 the social security COLA is 2.8%. In the example above, if you started your social security at age 62, you would be receiving $1,164 per month. In 2019, because of the COLA, your monthly pension would increase by 2.9% to $1,198. If they increased your base social security benefit, prior to the WEP reduction, you would have the higher $1,208 after the COLA adjustment. It’s not a huge deal, but something that adds up over time.
The WEP reduction is confusing and can make determining your social security benefit seem impossible. Luckily, social security has put together a fairly simple calculator that allows you to determine your social security benefit after a WEP reduction. I’ll let the calculator deliver the bad news, so I don’t have to this time.