Whether you’re retiring soon or are decades away, you need to know how Social Security works. This income source has protections in place against inflation and is guaranteed to last for life. It will be important to you in retirement, so you should understand it now.
Specifically, you owe it to yourself to know how your benefits will be calculated.
The formula Social Security uses to calculate your benefits
Social Security benefits are earned benefits based on your wages over the course of your career. So it’s no surprise the Social Security benefits formula takes your earnings into account. Specifically, when your benefit is calculated:
The Social Security Administration adjusts your wages over your career to account for wage growth. You get credit for wages up to an annual “wage base limit.” In 2022, the wage base limit is $147,000.
Then, your Average Indexed Monthly Earnings (AIME) is calculated based on average monthly earnings during the 35 years when your wages were highest
You will then receive benefits equal to a percentage of your AIME. The specific percentage depends on what you earn. Specifically, you receive:
90% of AIME up to a first “bend point”
32% of AIME up to a second “bend point”
15% of AIME up to a third “bend point”
The bend points are income levels based on average monthly earnings. They change annually, and the ones that apply to you are those in effect when you turn 62. For anyone turning 62 in 2022, the first bend point is $1,024, and the second is $6,172.
So, if your average monthly earnings in the 35 years you earned the most were $7,000, you would receive 90% of your earnings up to $1,204, 32% of your earnings between $1,024 and $6,172, and 15% of your earnings in excess of that amount, so 15% of $828.
This calculation would give you your primary insurance amount (PIA). That would be available to you at your full retirement age, which is between 66 and four months and 67 if you were born in 1956 or beyond.
Your benefits would then be adjusted up if you waited beyond your full retirement age, since you could earn delayed retirement credits between FRA and 70. But if you claimed earlier than FRA, your PIA would be adjusted down by early filing penalties.
Why do you need to know the benefits formula?
So why does knowing this formula matter? First, you can make more informed choices if you’re aware of how the benefits formula works.
Specifically, by knowing that your benefit is calculated based on an average of 35 years of earnings, you can make sure you work for at least 35 years. You can also decide you’d rather work longer to increase this average. If you are earning a lot later in life, each extra high-earning year you rack up would replace one lower-earning year in your formula.
You can also be more realistic about assessing what role your benefits will play. Unless you have very low earnings, you’re only going to get benefits equaling a small percentage of what you make. So Social Security isn’t going to come close to replacing your preretirement earnings. Instead, for most people, it replaces about 40% of what you were earning before leaving the workforce.
Understanding this means you can be sure you have plenty of savings to supplement your benefits. Finally, you can also make smart choices about when to claim benefits with the knowledge that you’ll get less monthly money (but more checks) if you file early or get larger payments, but less of them, if you delay.
Since Social Security will be an important income source, understanding all of these realities lets you make the most of your benefits so you can have a more comfortable life as a retiree.
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