Geo-arbitrage and US social security pitfalls

6/6/2022

Though many people don't believe that social security payments will be around when they retire, other financial experts disagree. Achieving FIRE with geo-arbitrage is a very attractive proposition, but there are some pitfalls that can cause you to miss out on free money in the event that social security is still around by the time you become eligible. Read on for the details and planning opportunities.

Common geo-arbitrage setups

Geo-arbitrage in simple terms is using your geographic mobility to take advantage of lower tax rates, lower cost of living, or even higher incomes. Some people may do domestic geo-arbitrage but for the purposes of this blog, we're going to focus on international geo-arbitrage. Here are a few sample setups, leave a comment of others you want me to cover.

Moving to another country but settling in longer term, you become a tax resident of your new country of residence and pay into their local income and social insurance tax systems. You might:
- Be employed by a company in your local country
- Be employed by a US company
- Start your own business by forming a corporation (a distinct legal entity that pays its own taxes)
- Start your own business by forming a sole trader/freelancing (usually taxed directly to you)
- Be fully retired and no longer earning any income from your physical or mental labor (only passive income from your investments)
Going full nomad, moving from country to country without establishing tax residence anywhere you go (usually staying less than 90 days becuase of visa reasons).
- The same list above could apply to you with the exception of bullet 1. Some digital nomads commonly form companies in the US but they may also form companies outside of the US. The reasons for this are outside the scope of this blog.

Assuming you are reading this blog as a US citizen or US greencard holder, then in the first scenario you are tax resident of two places, the US and your country of residence. In the second scenario, you are only tax resident of the US.

Social security basics: how benefits are calculated

Most international travelers I speak to have no idea how US social security works for their situation. It's hard to find answers and it's so far off that people just basically don't think about it. They hope they will get some magic money when they hit the governement benefits age. I was that person once too.

Disclaimer before we get started: I don't make residence or financial planning decisions based on the discussion we are about to have about social security. I live where I want to live and I hope you do to. I am also not a financial planner. This blog is a collection of knowledge I've learned along the way from doing research and talking to the social security administration.

What I hope you get from this information: knowledge in order to make slightly better and more informed choices when presented with two or more alternatives. One small little adjustment could mean the difference between "free money" in retirement or zero free money. I put free money in quotes there to appease the people that believe that social security will be totally gone when they hit government retirement age and therefore plan their financial future around getting nothing.

Here we go...

Who is eligible (also called: entitled) to receive a US social security benefit in retirement?
Assuming you earn more than $6,040 per year, you need to have lawfully worked 10 years to become eligible. I have over simplified this for purposes of the discussion and you can find further depths of eligibility on the SSA.gov website.

What does "lawfully worked" mean?
In simple terms, it means that your income was reported in your US Form 1040 individual tax return and you paid social security taxes on it. As an employee, that usually comes out of your paycheck as what is referred to as "payroll taxes". If you're an entrepreneur, then you would have paid this through the Schedule SE attached to your US Form 1040 which calculates your self-employment earnings and self-employment tax (the payroll tax equivalent for self-employed). If you've been working under the table then you have not been building credits.

How do you know how many credits you have so far?
You will annually receive a statement from the Social Security Administration (SSA) but I prefer to make an account on the SSA.gov website and simply login to see my credits.

When you retire, how is the amount you get paid each month calculated?
I am over simplifying for purposes of this discussion but the amount you get paid in retirement is based on a formula that is derived from the average of your 35 highest earning years. Like above, your annual earnings needed to either hit the SSA records through 1) employment payroll taxes or 2) through Schedule SE self-employment tax. You can find further depths of the calculation on the SSA.gov website.

To illustrate what this means for the rest of our discussion, I ran the following information through the SSA.gov simple online benefits calculator. I used a person born in 1970, who will retire at 65 years old, and who earns $75,000 per year for 35 years. I did not increase the wage for inflation just for the sake of being able to copy/paste the same number into the calculator. I then ran the calculation again but for only 15 years. This will matter later in the discussion. Here are the results in today's dollars.

35 Years of Earnings $75,000
Monthly Benefit: $2,642

15 Years of Earnings $75,000
Monthly Benefit: $1,840

The main take away here is that for all of those 20 years with 0's (zeros) in the SSA records, your monthly benefit will drop in retirement. Here are a few reasons/ways that someone might have 20 years of zeros in their SSA records:

They earned their wages under the table (didn't pay taxes on it).
They took a break from work to be a stay at home parent.
They moved abroad and paid into the social insurance system of another country.
They moved abroad and paid into no social insurance systems of any country.

We are here today regarding those last two.

Enter: the dreaded WEP.
WEP stands for Windfall Elimination Provision which was created to provide fairness to the system due to people that might have low credits or income in the system, and therefore artifically appear as "low income" when in reality they were receiving social insurance payments from other sources. This is due to the calculation of benefits being weighted in favor of lifetime low income earners. Legislatively, it makes sense. Mathematically, it creates a double dip hit to foreign earners (i.e. international migrants).

I took the example above and I added in what happens with the WEP adjustment into the 3rd column. I ran the calculation, in today's dollars, to see what would the monthly Netherlands social insurance benefit be paid the US migrant who moved to the Netherlands to work their remaining 20 years. This amounts to USD $524 at today's exchange rate (30 April 2022). This was already adjusted for the fact that the amount would have been $1,311 with 50 years of service/residence in the Netherlands. The SSA factors in this $524 benefit in their online advanced WEP adjusted benefits calculator with the following output:

35 Years of Earnings $75,000
All in the US
Monthly Benefit: $2,642
Foreign Benefit: $0
Total Monthly: $2,642

15 Years of Earnings $75,000
No WEP Adjustment
Monthly Benefit: $1,840
Foreign Benefit: $524
Total Monthly: $2,364

15 Years of Earnings $75,000 + WEP Adjustment
Monthly Benefit: $1,613
Foreign Benefit: $524
Total Monthly: $2,137

Isn't that a double-dip?? You would be right to ask...
In my personal opinion? Absolutely it is. But we aren't going to dive into the merits here of how the calculation works, we just want to use this blog to become more knowledgable about these outcomes. This is mathematically a double dip since in the middle column with no WEP adjustment, the US SSA monthly benefit was already reduced dramatically by the presence of 20 years of zeros, which brings down the average of the 35 highest incomes. Those 20 years are instead reflected in the foreign benefit calculation. But then the $1,840 gets adjusted again because this individual is in receipt of the $524 monthly benefit. You can see in the right hand column that this person would receive a social insurance benefit of $2,137 between the payment from the US and the payment from the Netherlands, for 50 years of service. If that same person had worked the same 50 years all inside the borders of the US, then they would receive what we see in the far left column of $2,642.

There are 3 primary ways that your SSA benefits will not be WEP adjusted (in 95%+ of cases):

if you have 30 or more years of credits in the US system
you are receiving the foreign benefit by accessing the US totalization agreement (covered next)
you are receiving the foreign benefit solely based on residence rather than income (if you lawfully lived in a country for a number of years regardless if you worked or not)

Planning and pitfalls for international migrants and nomads

Totalization agreements for migrants without enough credits in any country
The US government has entered into agreements with a number of countries called totalization agreements. These agreements dictate which country gets to collect/tax the worker and collect social insurance taxes so that the worker does not get taxed twice (once by the country of citizenship and again by the country of residence). These agreements also ensure that an individual is "made whole" when moving between a lot of different countries in the their lifetime. For example, if you work in the US for 8 years and Ireland for 8 years, you may not be eligible for social security benefits in either country because you didn't work 10 years in each. With a totalization agreement between the US and Ireland, both countries will recognize the credits from the other country which then makes the worker eligible for benefits in retirement from both countries systems (8+8=16).

The totalization agreements also work in cases where you have enough credits in 1 country but not the other(s), to ensure that they count towards eachother. So if I have 15 years in the US system but only 2 in the Irish system, then I would be eligible to receive a social security benefit in the US without the need for the totalization agreement but would need to use the totalization agreement to become eligible for a payment (though quite small) from the Irish government when I reach retirement. This is an important distinction I illustrate with this example:

15 years working in the US: eligible for social security benefits under the US system (a payment from the US government).
2 years working in Ireland: must "access the US-Ireland totalization agreement" in order to be eligible for a social security benefit under the Irish system (a payment from the Irish government) - said differently: I would not otherwise be eligible for the Irish benefit if the US totalization agreement was not present.

Totalization agreements and the WEP good news.
If you do a search for the word "totalization" on this SSA.gov WEP history page you will find that certain foreign pensions paid as a result of "accessing the totalization agreement" will not be WEP adjusted. This is further confirmed in the WEP screening tool on the SSA website. "Pensions" in this context means the government social insurance benefits of a foreign country.

Residence based social insurance benefits and the WEP good news.
In the case that a country pays its government social insurance benefits based on your residence in that country, and not based on your working/income, then in most cases there will be no WEP adjustment on that payment. An example is the Netherlands which pays a monthly benefit based on your presence in the country. This is very beneficial for stay at home parents that would receive quite low (or no) benefits in a country that bases its social insurance benefits on income you paid into the system (like the US).

Planning opportunities: examples
As was mentioned earlier - social security is going to be such a small amount of a FIRE journey that location / residence decisions should not be based around it. But you could have some small wins for "free government money" later by being a little bit more knowledgable. Here are some examples:

You have over 10 years of credits in the US, and you currently live in a country with a totalization agreement with the US. You have 9 years of credits in the country you live in, and they have a 10 year requirement for social insurance benefit eligibility. Your work wants to relocate you to a new country, and you can do it this year or wait until next year. Ignoring all other factors that go into a decision like this, if you moved this year then when you hit retirement age you can receive a social insurance benefit paid from your current country of residence and your US social security benefits will not be reduced by the related WEP adjustment. This is because the social insurance benefit paid to you would be from "accessing the US totalization agreement" for the 1 missing year (of 10). If you moved after the 10 year mark then you would be eligible for social security benefits in that country without needing to access the totalization agreement to make you whole and such social security benefit payments do create a US WEP adjustment.
You are deciding between living/working in two different countries, one of which has a US totalization agreement and the other which does not. This could be a factor to put in a pros/cons table to aide in your decision so as not to lose out on any benefits in retirement. Additionally, and depending on your circumstances, running a business in a country without a US totalization agreement could cause you to be double taxed today (e.g. freelancing in India).
You are deciding between living/working in two different countries, one of which is income based social insurance benefits and the other is physical residence based. This could be a factor to put in a pros/cons table to aide in your decision if your spouse would like to be a stay at home parent. So long as they are present in the country, they would be eligible for a government benefit payment in retirement where in an income/working based system they would not.

Social security pitfalls: examples
The following can cause some real headaches so keep an eye out:

Incorrectly using the Foreign Earned Income Exclusion on employment income: I commonly speak to people that have moved to Portugal full time, become tax resident there, and are trying to take advantage of exclusions from Portuguese tax for "foreign sourced income". These people are usually doing marketing, software developing, or something else that depends on their physical services. They then go to file their US taxes and claim the Foreign Earned Income Exclusion on that same income and paying $0 or almost $0 in US taxes. No taxes anywhere that sounds great! Two problems though:
- This is incorrect since the income cannot be foreign to both sides. If you claim it is foreign income in Portugal then it must be US income which cannot be excluded under the FEIE. If you claim it is foreign income in the US under the FEIE then it must be Portuguese income subject to Portuguese income and social insurance taxes (which are very high). A further point to make here is that services are sourced based on where they are performed (98% of the time) so if you are doing work that requires your physical or mental labor in exchange for payment, then it is sourced where you perform it. If you are working remotely in Portugal then that is likely to be Portuguese income subject to Portuguese income taxes and social insurance taxes.
- Even if that no taxation anywhere was correct, you would be excluding the income from everywhere and not making any social insurance contributions to any country. You will have a rude surprise waiting in retirement when you apply for your US social security check and it's super small (or zero). This is because you were excluding the income from US taxes so you have many years of zeros in the 35 year average, and you have no Portuguse social security payment because you never paid into their system. This can also be dangerous for disability benefits. If you ever became disabled you may find yourself without any (or very little) government social/monetary support.
Incorrectly using the Foreign Earned Income Exclusion on sole trader / freelancing income: some people incorrectly think that they can exclude all of their foreign source income from all US taxes however this is not correct. Schedule SE, where self-employment taxes are calculated, cannot be excluded even when using the FEIE correctly. Social insurance taxes and contribution credits are calculated by way of this schedule. If you are paying social insurance taxes in the country you live in, and that country has a US totalization agreement, then you can be exempt from calculating Schedule SE self-employment taxes with an attachment called a Certificate of Coverage. But if you are a digital nomad who jumps to a new country every 90 days, then you are likely not paying social insurance taxes to another country and therefore are not exempt from Schedule SE self-employment taxes in the US. This can create a surprise tax bill for freelancers that don't plan accordingly.
- If you're a digital nomad that has been incorrectly excluding your foreign source income from your Schedule SE self-employment taxes, you could be at risk of a very small to non-existent social security payment when you hit retirement because your income has not been credited into the SSA accounts.
Freelancing in a country without a US totalization agreement: most countries in the world collect social insurance taxes on employees and freelancers. If you reside full time in one of these countries that does not have a US totalization agreement in place (e.g. India, Bulgaria, etc) then you will be at risk of paying social insurances twice. This is because you must calculate Schedule SE self-employment taxes in the US (it cannot be excluded by FEIE) and you cannot take a tax credit against the taxes you paid to the other country.
- Many people looking to work abroad are easily lured by the bloggers calling on cheap income taxes (like 10% in Bulgaria!) but 9 times out of 10 they fail to mention the pitfalls of very high social insurance taxes (which are usually not subject to tax discounts).

TLDR: in summary

Paying social insurance taxes provides security to you both for income replacement in case of disability and income replacement in retirement / old age. You should evaluate your circumstances to find the most optimal solution for you given 3 possible outcomes:

Paying social insurance taxes nowhere: you should be investing all of that savings as you are 100% self-insured against disability and old age at this point, you won't get a social security benefit payment from any countries.
Paying social insurance taxes to 1 country at a time: you have some planning opportunities to not encounter the dreaded WEP adjustment on your US benefits:
- Give positive weighting to country choices which allow you to "access local benefits via the US totalization agreements" (rather than qualifying for benefits without a US totalization agreement or rather than working/living full time in a country without a US totalization agreement).
- Give positive weighting to country choices that provide social insurance benefits based on residence and not income/work (e.g. Netherlands) in cases where one partner wishes to stay at home with children or other dependents (or otherwise not take up paid employment).
Paying social insurance taxes to 2 countries and getting double taxed: getting taxed twice is awful already when you work/live full time in a country with no US totalizationa greement, but you may also be unable to access some of the benefits in retirement depending on the circumstances of the country. Double taxation can happen in countries like India and Bulgaria, amongst others.