Many Americans take Social Security early, at age 62, because they really need it. They’re in poor health or unemployed or both. Others take benefits early because they’re worried they’ll lose out on what’s rightfully theirs if benefits are reduced. But few people try to figure out the best age to take Social Security—and that’s a serious mistake.

Even though it’s challenging, calculating the best time to take benefits is well worth it, especially given that Social Security represents about one-third of the average retiree’s income.

What’s key is evaluating the so-called break-even period to determine whether it would be better to delay Social Security benefits (delaying them means a higher monthly benefit), take a reduced benefit early, or start them at “normal” retirement age. Of course, there’s a good reason why so few people really do the calculations.

“When to begin Social Security retirement benefits is a challenging question that vexes many financial planners and clients,” Michael Kitces, editor of The Kitces Report, wrote in a recent issue. Living beyond the break-even point can produce large amounts of wealth relative to the risk. But delaying Social Security benefits does represent a serious risk, Kitces said: If you wait and then pass away before claiming your benefit, it really messes things up for your widow. Still, there are situations in which delaying Social Security retirement benefits can pay off significantly.

“Is it better to begin payments early, or to delay Social Security and forfeit current payments to receive a larger income stream in the future?” he said. “Although the analysis of such a question would seem relatively straightforward, the complex rules of Social Security make the evaluation more difficult, especially when evaluating the implications of living beyond the so-called ‘break-even’ point.”

Putting if off can pay off
One of the biggest risks to your retirement plan is unexpected longevity—living longer than you expect and having to fund additional years of retirement. “The decision to delay Social Security provides tremendous additional value, at the exact time that it is needed,” Kitces said.

Another risk: High inflation. “To the extent that inflation turns out to be unexpectedly high, delaying Social Security benefits also turns out to be an effective inflation hedge, because the value of delaying increases in higher inflation environments,” he wrote. Though not the case now, during high inflation, which many predict on the horizon, you would get larger cost-of-living adjustments.

Also, a low rate of return on investments poses a risk. “The decision to delay benefits also turns out to be an indirect hedge to poor returns in the portfolio,” Kitces wrote.

How to decide
“At the most basic level, the decision about whether or not to delay Social Security retirement benefits represents a very straight-forward trade-off,” Kitces wrote. “You can either receive cash payments now, in your pocket, to spend or invest however you choose, or you can give up those payments in exchange for receiving a higher stream of income for life at a future date.”

Here are the things you should consider to make a more informed decision:

1. What’s your normal retirement age?
The first order of business: You need to know what your normal retirement age, or NRA, is. If you were born in 1937 or earlier, it’s 65. If you were born in 1960 or later, it’s 67. And if you were born between 1938 and 1959, it’s somewhere in between. Of note: If you were born in 1943, your NRA is 66. And since it’s now 2009, that means anyone born in 1943 is now at NRA, the age at which you can receive your full Social Security benefit.

Once you know your NRA, you can calculate how much Social Security benefits will be increased or decreased if you choose to take your benefit later or earlier than your NRA. Take your benefit before NRA, and it’s reduced by 5/9ths of 1 percent for each month the benefits begin early, up to a maximum of 36 months before your NRA. Take your benefit after your NRA and the benefit is adjusted upward, depending on the year in which you were born, due to the “delayed retirement credit.” With delayed retirement credits, at least under current law, a person can receive his or her largest benefit by retiring at age 70. A person born in January of 1943, for instance, who waited until 50 months after reaching full retirement age would have a benefit of about 132% of their primary insurance amount.

2. Will you be working?
Next, you need to determine whether you’ll be working, especially if you have not yet reached full or normal retirement age, according to Kitces. Because of Social Security’s earnings test, Kitces says it’s almost always a bad idea to take Social Security benefits early if you have earned income greater than the earnings test threshold. Social Security withholds benefits if your earnings exceed a certain level, called a “retirement earnings test exempt amount,” and if you are under your NRA.

But it’s also important to note that one of two different exempt amounts applies, depending on the year in which you reach your NRA. Under the earnings test, your Social Security benefits are reduced by $1 for every $2 of earned income that you have in excess of $14,160 per year. But if your NRA is 2009, your benefit is reduced $1 for every $3 of earned income in excess of $37,680.

3. How’s your health?
At the end of the day, Kitces said the most significant factor in the entire process of evaluating the decision to delay Social Security is whether you’re likely to live long enough to receive value from higher monthly benefits. The shorter your life expectancy, be it because of health, genetic, or other relevant factors, the less prospective value to delaying Social Security. If you’re not expected to live long enough to reach the break-even point, “it will virtually always make sense to begin benefits as soon as possible, and get as many payments as possible,” Kitces said.

The tradeoffs
If you don’t plan to automatically defer benefits or start benefits early, Kitces said, “you have to evaluate the prospective tradeoffs between electing benefits early, or delaying benefits with the risk of not living to the break-even period and the opportunity for wealth creation by living beyond it.”

To do this, you first have to pick a conservative growth rate, as well as an assumption for inflation. What’s more, you need to look at your retirement cash-flow needs and other income sources and investments, the risks you might face in retirement, and your longevity. Once you have a sense of the tradeoffs, you can come up with the best possible answer for your situation, rather than the rule-of-thumb case.

The caveats
If you’re married, you’ll need to figure out what impact your decision regarding the timing of your Social Security benefits will have on both spousal benefits and widow’s benefits. Also, you’ll need to figure the effect of taxes on your decision.

“Social Security benefits have their own unique rules for determining the amount of benefits that will be subject to taxation, and there is significant interplay between the taxation of Social Security benefits and other aspects of the client’s planning situation that may create taxable income and affect the taxability of Social Security,” Kitces said.

There you have it. You can certainly take Social Security early if you want. But given that Social Security might represent one of your largest assets and perhaps your most dependable income stream, wouldn’t you rather know that you had it as close to right as possible?

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