How are Social Security Benefits Calculated?
Ten thousand baby boomers are retiring daily. Almost all can expect a piece of Social Security's billion dollar pie. Many may even plan to rely on those benefits for more than half of their future household incomes. Yet most don't know how those benefits are calculated.
The Social Security Administration does its best to inform. Its website lets you look at your account and estimate your benefits. Its publications tell you that your lifetime earnings are adjusted to account for changes in average wages since the year the earnings were received. Social Security calculates your average indexed monthly earnings during the 35 years in which you earned the most. The SSA then applies a formula to these earnings to arrive at your basic benefit or primary insurance amount.
Huh? What does that mean? Social Security calculates progressively. The intent of the insurance is to provide a livable income to all retirees, not to give back what was paid in to the system. Social Security’s indexing reflects economic changes. It doesn’t just average earnings. It takes inflation into account.
That means a worker may see earlier earnings take on more weight than recent earnings. Social Security’s next formula takes a percentage of a worker’s average indexed monthly earnings and comes up with a primary insurance amount. Those percentages change at income breakpoints.
What are those percentages and what do those breakpoints look like? If a low-wage worker makes less than $10,000 per year, she may have almost all of her pre-retirement income returned. If a worker made an average of $30,000 per year over 35 years, she may see 50% of her pre-retirement income returned. For earners in the $100,000 bracket, that return could be as low as 25%.
The implications add unexpected complications to retirement planning. Deciding to take a higher-paying job or work an extra year or two will not necessarily add value to a Social Security account. Working longer can only have an impact on future benefits if you’ve had a short career and high earnings or if in you’re a long-term, low-wage worker. Be prepared. Go too far above an income breakpoint? Expect your returns to diminish.
Other factors in benefit calculations include your age of retirement, spousal and survivor benefits, and the Windfall Elimination Provision. It’s probably never a good idea to retire at 62 unless your spouse is the higher earner. If you have worked at a government job for any length of time in your career and have not paid into the Social Security system for that time, you may be subject to different insurance calculations.
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