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Social Security closes "tax-free loan" loophole

People aren't stupid. If they see a way to earn a return with little risk, they'll act on it.

And that brings us to the topic of today's post: Did you know that for many years, some people have been getting interest-free loans from the Social Security Administration?

It's true. Social Security effectively allowed seniors to get temporary use of tens of thousands of dollars interest-free — until this week.

A 2009 U.S. News article described how it worked:

A little-known law allows Social Security recipients who are already collecting benefits to change their mind[s] and start over. An individual can claim Social Security at age 62 and then reclaim again for an enhanced payout at age 70, provided he or she pays back every cent already received.

No interest is charged on this "loan" from Social Security. So, an individual who doesn't need to spend their Social Security income on immediate expenses could feasibly invest the money and keep the interest. Upon paying back the principal, these investors will get higher Social Security checks for the rest of their life....

In order to take advantage of this zero-interest loan you need to be able to afford retirement without the monthly benefit. Boston College calculated that approximately 30 percent of men and 32 percent of women have enough financial assets in 401(k), IRAs, and other liquid investments to make it to age 70 without using their checks.

The Boston College study (PDF) referenced above didn't say how many households have been taking advantage of the claim/withdraw strategy, but it estimated that between $5.5 billion and $11 billion has been paid out annually to Social Security recipients who use the money for a while, earn a return on it, and then pay it back.

This week, however, the Social Security Administration slammed the door on that strategy, shortening the legal period between taking benefits and later withdrawing an application to one year. SSA also restricted the suspension period.

Here's an excerpt from a Social Security news release (PDF):

The Social Security Administration today published final rules, effective immediately, that limit the time period for beneficiaries to withdraw an application for retirement benefits to within 12 months of the first month of entitlement and to one withdrawal per lifetime.

In addition, beneficiaries entitled to retirement benefits may voluntarily suspend benefits only for the months beginning after the month in which the request is made.

The agency is changing its withdrawal policy because recent media articles have promoted the use of the current policy as a means for retired beneficiaries to acquire an "interest-free loan." However, this "free loan" costs the Social Security Trust Fund the use of money during the period the beneficiary is receiving benefits with the intent of later withdrawing the application and the interest earned on these funds.

The interesting thing is that Social Security rules have allowed for this "interest-free loan" arrangement since the 1960s, but the matter got little attention until the Boston College study mentioned above was published last year.

Here's something to think about: Were the people using the claim/withdraw strategy unethical? Or were they simply wise to use the regulations to their advantage?

We'll leave that for you to ponder.

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