You work all your life so that you will have a comfortable retirement, and for most of us, Social Security is a crucial part of retirement planning. Thus, it is important to understand how retirement benefits work, and especially how Social Security benefits are calculated. Understanding how Social Security benefits are calculated helps you make more informed financial decisions.
Qualifying For Social Security
Before we detail how Social Security benefits are calculated, it is important for you to know that you need to accrue 40 credits to even qualify for Social Security benefits. Presently, i.e., in 2023, you need to earn wages and self-employment income of $1,640 to earn one credit.
Moreover, you could earn up to four credits in a year. To earn all four credits in a year, you need to earn $6,560 (in any period of that tax year). To earn 40 credits, you must meet the minimum wage or self-employment income for at least 10 years (which need not be consecutive). The credit system works the same way for self-employed and those who run their own business.
It must be noted that once you earn 40 credits, earning more credits will not boost your benefit payment. Understanding how Social Security benefits are calculated could help you to boost your benefits.
Before we move on, you must also know about Average Indexed Monthly Earnings (AIME). Basically, AIME is used to determine the primary insurance amount (PIA), which in turn, helps to calculate an individual’s Social Security benefits. Simply, AIME approximates a person’s lifetime earnings using present wage levels as a benchmark.
How Are Social Security Benefits Calculated?
When discussing how Security benefits are calculated, we are not talking about the formula. Rather, we need to understand the components that go into calculating Social Security benefits. So, the following points will help you to understand how Social Security benefits are calculated:
Relation To Average Wages
Retirees need to know that the amount of benefits they get is directly related to the money they earn in their working life. When claiming the benefits, the Social Security Administration (SSA) adjusts your working life earnings to account for wage growth.
The SSA takes into consideration this adjusted wage to give you a percentage of it as your standard benefit. Retirees get this standard benefit at full retirement age (FRA).
If you claim the benefits before your full retirement age, you could be subject to early filing penalties of up to 30%, depending on how early you claimed the benefit. On the other hand, if you claim for benefits after full retirement age, then you could get late filing credits that will boost your benefits.
Your working life earnings are the biggest determinant of your retirement income, so you should always strive to increase earnings when possible.
Not All Earnings Years Count
The SSA doesn’t necessarily use every year’s earnings to calculate your AIME (average-indexed monthly earnings). The SSA considers the 35 years in which you made the most money.
So, if your working years are less than 35, then there will be some years when the SSA counts your earnings as $0 for the calculation of benefits. If your working years are more than 35, then the SSA won’t consider the years with lower earnings.
For example, you worked 36 years, and your lowest year’s earnings during that period was $10,000. The SSA won’t consider that year’s earnings of $10,000 to calculate your benefits.
So, it is important that you try to work for 35 years at least. Your benefits will be higher if you work for more years, which could eventually translate into higher benefits when you retire.
Beware Of The Wage Base Limit
Although the SSA considers the years with higher salaries, not all high earners get the benefit of those wages. This is due to the wage base limit.
You don’t have to pay Social Security taxes on the earnings above the wage base limit. Moreover, earnings more than the wage base limit aren’t considered for calculating benefits. The wage base limit is $160,200 in 2023.
So, no matter how big your paycheck is, it won’t boost your retirement money if it is more than the wage base limit.
Talking about the formula to calculate the benefits, you need to know that AIME (average-indexed monthly earnings) is divided into three parts, called bend points. These bend points are adjusted every year for inflation, and the benefit is the sum of these bend points.
The three bend points (for 2023) are:
- 90% of the first $1,115 of AIME.
- 32% of the earnings between $1,115 and $6,721
- 15% of earnings above $6,721.
Let’s consider an example to understand the calculation better. Mr. A is 62-year-old and his total indexed earnings over his 35 highest-earning years were $2.5 million. In this case, AIME for Mr. A will be $5,952.38 ($2,500,000/420 work months).
The first bend point will be 90% of $1,115, or $1,003.50.
The second bend point will be 32% of $4,837.38 ($5,952.38 less $1,115), or $1,547.96.
Since Mr. A’s income is less than $6,721, the third bend point doesn’t apply.
Now, if we add the first two bend points, we get $2,551.46.
Benefits are rounded to the next-lowest dime, so Mr. A’s benefit payment will be $2,551.40.
Although you now know the formula to calculate Social Security, actually calculating the benefits can be complicated. Instead of calculating, it is better for you to understand how your benefits are determined. Once you understand the above points, it will be easier to make your career choices, including how many years you should work and what salary to aim for.