Understanding Social Security benefits will pay off in golden years

The Social Security system was never intended to be the sole means of support for retired Americans, but it is nonetheless the most important source of income for many retirees.

However, what Americans do not know about Social Security benefits can really hurt them as they plan out their golden years, say financial advisors.

There are a variety of points that most Americans are just not aware of when it comes to that important government program. For instance, did you know that you can take Social Security retirement benefits early? Or, that Social Security isn't merely a retirement benefit.

Also, for those who can handle it financially, it's a great economic strategy to take retirement benefits late, as late as age 70.

Additionally, nonworking spouses, even those who have never had an income, are eligible for Social Security benefits.

With benefits from the program accounting for an average 38.2 percent of income for people over age 65, according to the Employee Benefits Research Institute, making the most of those benefits is crucial. (Social Security benefits comprise an even higher percentage of income for less-wealthy Americans.)

Laurence Kotlikoff, an economist at Boston University and president of personal finance software firm Economic Security Planning, said he has three basic rules for maximizing Social Security benefits: wait to collect the benefits; collect all the benefits you can, including spousal and survivor benefits; and don't let either rule mess up the other one.

The key is balancing what you're willing to do now with how you'd like to live in retirement. "Nobody wants to starve now and binge when they're 90, or vice versa," Kotlikoff said. "The idea is to have a consistent standard of living through your retirement."

The biggest decision regarding Social Security is when to start collecting benefits. Americans who have paid into the system can start as early as age 62 or as late as 70. There are powerful incentives to wait.

The maximum monthly benefit in 2013 for a person of the full retirement age (FRA) of 66 is $2,533.

People who decide to begin drawing benefits as early as age 62 will see that monthly benefit reduced by around 24 percent, to $1,923—for the rest of their lives. Conversely, if they wait until 70 to begin collecting, the benefit is a whopping 32 percent more than at the FRA, or $3,350 per month.

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"The longer you wait, the greater the benefit," said Carla Masselink, a certified financial planner and senior vice president, investments, at MKS Wealth Advisors of Raymond James.

Masselink noted that between ages 67 and 70, the Social Security benefit grows by 8 percent annually.

"In this marketplace, an 8 percent guaranteed return is very good," she said.

The decision will, to a large degree, depend on individuals' health, their family situation and whether they have other resources to sustain them. There are cases where drawing benefits early may make sense.

Single individuals with a terminal disease may not anticipate living long enough to collect larger benefits later. Individuals with no other retirement resources and lacking the ability to generate income also may need to draw benefits early.

However, in most cases, it makes sense to wait. Masselink helps her clients decide what to do by calculating the break-even point—usually between the ages of 74 and 78—when total benefits collected by those who opted to wait will match or exceed the amount they would have received by getting more checks, but at lesser amounts, from an earlier retirement date.

"It's a nice idea to keep working if you can and go for the bigger benefit later, particularly if you don't have a lot of other assets," she said.

The issue gets more difficult for couples, who need to consider spousal and survivor benefits. Nonworking or lesser-earning spouses of Social Security beneficiaries are entitled to 50 percent of the primary, or higher-earning, income producer's benefits when both parties are of FRA. (An ex-spouse may also claim this spousal benefit, if the former marriage lasted more than 10 years and he or she did not remarry before age 62.)

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Alternately, lower-earning spouses of FRA may choose to claim their own full benefits if they're greater than the 50 percent spousal benefit. Spouses cannot claim the spousal benefit until their partners have filed their own claims.

For their part, surviving spouses are eligible to take either 100 percent of their deceased partners' FRA benefits or their own—not both.

Masselink said that a "file-and-suspend-claim" strategy can work for many couples. It enables the collection of a full spousal benefit starting at the higher wage earner's age of 66. The higher earner files the claim, enabling the partner to make a claim for spousal benefits, and then suspends his or her own claim.

"The higher earner's benefits then continue to accrue at 8 percent annually until they're 70 years old," she said. The spouse has the option to switch to collecting his or her own maximum retirement benefit at age 70.

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The strategy may not be right for everyone, however. The rules for calculating Social Security benefits are complicated, to say the least. The combination of factors at play—including health, expected longevity, spousal and family situation, and earning potential—produces a dizzying array of potential outcomes for people to consider.

"There are more rules for calculating Social Security benefits than there are in the tax code," said Kotlikoff. "It's a monster. My general guidance to people is not to try to do this on their own."

Instead, he suggests using software such as Maximize My Social Security, which he developed at Economic Security Planning. Users input personal data and the program crunches numbers to determine optimal claiming strategies. Similar tools—some free, some not—are available online from other companies and organizations, such as T. Rowe Price and AARP.

"You have to run through all the alternatives with good software," Kotlikoff said. "There's no other way to get the right answer."

—By Andrew Osterland, Special to CNBC.com