Social Security is an important part of most American’s retirement plan. In fact, nearly nine out of ten individuals age 65 and older receive Social Security benefits.
And for those who are receiving Social Security retirement benefits, it accounts for a large portion of their retirement income. As of 2019:
- 48% of married couples and 69% of unmarried persons receive 50% or more of their income from Social Security.
- 21% of married couples and about 44% of unmarried persons rely on Social Security for 90% or more of their income.
Despite being so important, many individuals are unaware of how their Social Security retirement benefit is calculated. Though, I don’t blame them for this. The rules for Social Security are extremely numerous and complex.
When explaining the rules to investors, I often have to refer to many different pages from the Social Security website, and from Social Security experts like Mary Beth Franklin, Laurence Kotlikoff and Devin Carroll.
In this article, I’m going to make the bold attempt to explain everything about how your Social Security retirement benefit is calculated. This way, you’ll understand why your monthly payment from the Social Security Administration (SSA) is the amount that it is.
Wherever possible, I’ll reference and link out to the Social Security website explanations and calculators, so you can verify/access the information for yourself, straight from the source.
Be warned, this article will get into the weeds! It will use official Social Security jargon like “age of eligibility” and acronyms like “AIME” (don’t worry if you don’t know what these mean yet). This is because I want to be as accurate and specific as possible. And, if I’m being honest, I’m more so writing this article so I don’t forget all the research I just did.
Note that the focus of this article is strictly on how your Social Security retirement benefits are calculated. I will not cover any of the following topics:
- History of Social Security
- Various strategies to maximize your expected Social Security benefits
- Social Security disability benefits
Now, after the longest introduction I have ever, and hopefully will ever, write… Let’s get to it.
1. Paying Social Security Taxes
The amount of income you earn throughout your working career is the primary determinant on the size of your Social Security retirement benefit.
Most workers in the US pay a tax called for under the Federal Insurance Contributions Act (FICA). Generally, you pay Old Age and Survivors Insurance (OASI) taxes of 5.30%, and Disability Insurance (DI) Taxes of 0.90%. Together, these are called OASDI taxes and add up to 6.20% of your earned income.
If you are self-employed, instead of FICA tax, you’ll pay Self Employment Contributions Act (SECA) tax. These rates are double those of FICA, coming in at 10.60% for OASI Tax and 1.80% for DI Tax. In total, OASDI taxes for self-employed individuals are 12.40%.However, the amount of your earned income that is subject to OASDI taxes is capped. This cap is called the Contribution and Benefits Base, and for 2019, the base is $132,900 per year. The Contributions and Benefits base is adjusted each year based off the National Average Wage Index (AWI), but uses a rather odd formula. This adjustment “ensures that a worker’s future benefits reflect the general rise in the standard of living that occurred during his or her working lifetime.”
The Contribution and Benefits Base is important for 2 reasons.
- Any earned income you have in excess is not subject to OASDI taxes.
- Any earned income you have in excess is not used in the calculation that determines your Social Security retirement benefits.
2. Becoming Eligible for Social Security Retirement Benefits
Paying OASDI taxes earns you Social Security Credits. In 2019, a worker earned 1 Social Security Credit for every $1,360 he/she earned per year, up to a maximum of 4 credits per year. So if you earn $5,440 or more in one year, you will earn the maximum Social Security Credits for that year. For most workers, you must earn 40 Social Security Credits to be eligible for Social Security retirement benefits from your own earnings record.
Quick recap. You pay taxes on your earned income. Paying taxes earns you credits. Once you earn enough credits, you will be eligible to receive benefits.
You can easily see how many credits you have earned, and if you have earned enough credits to qualify for benefits by looking at page 2 of your Social Security statement. You can access your Social Security statement by creating a my Social Security account online.
3. Finding Your Earnings History
The easiest way to find your earnings history is by again viewing your Social Security statement. Page 3 will list your historical earnings for each year.
The SSA puts out a sample statement for a hypothetical individual named “Wanda Worker” so you can see what I’m talking about. For our purposes today, we are only concerned with the column titled “Your Taxed Social Security Earnings” and not “Your Taxed Medicare Earnings.”
However, your statement will not show any future income that you plan on earning. So if you want to include future income when calculating your retirement benefit, you’ll have to estimate what your income will be.
You’ll notice that the SSA also makes an estimate about your future earnings (listed on page 2 of your statement). They use these estimated future earnings in their calculation of your expected future retirement benefit. They assume that your income will stay the same as last year, each and every year until you retire.
If that is true, then your estimated retirement benefits listed on your statement will be fairly accurate. If not, your future benefit may be very different.
4. Indexing Your Earnings
Once you have your earnings, the next step is to index them using the National Average Wage Indexing Series. This is important because earning $30,000 back in 1960 is very different than earning $30,000 in today’s dollars.
In order to properly index your earnings, you need to know your Year of Eligibility, which is the year in which you turn 62. For example, if you were born in the year 1957, your Year of Eligibility would be 2019 (2019 – 1957 = 62 years old).
Luckily the SSA makes obtaining your indexing factors pretty easy. They have a page dedicated just for this purpose. Simply type in your Year of Eligibility and the SSA will generate a list of your Indexing Factors for each year. If we continue using Wanda Worker, who was born in 1959, we will get the Indexing Factors listed below.
Once you have the Indexing Factor for each year, multiply your earnings by that year’s Indexing Factor to get your Indexed Earnings. If you’re working in a spreadsheet, it should look something like this (again, using Wanda Worker’s information).
This sounds easy, but there are a few not-so-obvious nuances to be aware of.
- Only your earnings for ages 59 and below are actually indexed. All earnings for ages 60 and above are not indexed. Instead, only the actual earnings amount is used. That is why you’ll see a 1.0000000 as the Indexing Factor for those years. The reason for this that there is a 2-year lag on reporting for the National Average Wage Index, so they can only index your earnings 2 years before your Age of Eligibility.
- Indexing Factors for future years must be estimated, since they have not occurred yet. So if your Year of Eligibility is after the current year, the SSA “will use average wage changes that were estimated under the intermediate assumptions in the latest Trustees Report.”
- The published numbers listed below as future estimates are rounded to far fewer decimal places. So if you are trying to calculate your index factors yourself, it will be very hard to get your numbers to match exactly. I recommend simply letting the SSA calculate your Indexing Factors for you.
5. Calculating Your Average Indexed Monthly Earnings (AIME)
After you have indexed all your earnings, you can now compare them with one another, apples-to-apples. You only use the 35 years in which you had the highest indexed earnings. If you worked less than 35 years, you will have some years with $0 of earnings.
Add up all your indexed earnings from your highest 35 years, and then divide by 35 to get your Average Indexed Annual Earnings. Divide that number one more time by 12 and round down to the nearest whole dollar to get your Average Indexed Monthly Earnings (AIME).
6. Finding Your Full Retirement Age (FRA)
Before you can calculate your Social Security retirement benefit, you must know when you are eligible to receive your full benefit. That age is called your Normal Retirement Age (NRA), or more commonly your Full Retirement Age (FRA).
Your FRA is determined from the year in which you were born. And can be anywhere from 65 (if you were born before 1938) and 67 (if you were born after 1959).
You can use the SSA’s Retirement Age Calculator to find your FRA, or just check page 2 of your Social Security statement.
7. Applying the Primary Insurance Amount (PIA) Formula
Now that you have your AIME, it’s finally time to apply the Primary Insurance Amount (PIA) formula. This formula determines your PIA, which is your Social Security retirement benefit if you begin receiving benefits at your FRA.
The PIA formula takes your AIME and breaks it out into 3 ranges. The point that separates each range is called a bend point. Each range has its own replacement rate, or the amount of income it will replace. The replacement rates decrease the higher your income. For 2019, the ranges and replacement rates are listed below.
Just how your earnings ares indexed, so are the bend points. So in future years, the bend points will not be the same. This means that if your Age of Eligibility is after the current year, you will have to estimate your bend points using the average wage changes that were estimated under the intermediate assumptions in the latest Trustees Report.
And remember that 2-year lag on reporting of the National Average Wage Index? That applies to bend points as well. So the bend points always increase at the index rate from 2 years prior.
Once you have the appropriate bend points for your Year of Eligibility, you can apply the formula to your AIME. There only 4 steps left.
- Multiply the 1st range of your AIME (before the 1st bend point) by 90%.
- Multiply the 2nd range of your AIME (before the 2nd bend point) by 32%.
- Multiply the 3rd range of your AIME (after the 2nd bend point) by 15%.
- Add up those 3 numbers to get your PIA.
You now have your PIA as of your date of eligibility, also known as your “Raw PIA.”
8. Factoring in Cost of Living Adjustments (COLAs)
Your Raw PIA is your PIA as of age 62. However, you must wait 3-5 years to claim your SS retirement benefits unless you want your benefit permanently reduced. That’s 3-5 years of potential inflation eating away at your PIA.
That’s why, since 1975, Social Security applies a Cost of Living Adjustment (COLA) each year after your Year of Eligibility. A COLA, if applicable for that year, is applied in December. Since Social Security always pays benefits 1 month in arrears, you will receive your first benefit with the COLA will be in January.
So if your Year of Eligibility is 2019, and you reach your FRA in 2023, your Raw PIA will get a COLA for years 2019, 2020, 2021 and 2022, but not 2023 because the COLA won’t be effective until the following year. Round this number to the next lowest whole dollar to get your PIA.
9. Accounting for Inflation
Technically this step is optional, but I highly recommend it. The PIA you calculated above is your true PIA (assuming your estimates of future income and the NAWI are accurate). However, this number is in future dollars, so it will appear to be more money that it really is
Let’s say your PIA is $2,000/month, and you’ll reach your FRA 20 years from now. If inflation is 2.6%, like intermediate assumptions of the Trustees Report estimate, that $2,000/month will only feel like $1,197/month.
It’s true that step #8, listed above, already applies a COLA from your year of eligibility (age 62) to your FRA, but inflation is not factored in for years before age 62.
Again, the Social Security Administration uses the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) to measure inflation, so I recommend also using that.
It’s usually a good idea to account for inflation when doing any financial planning. And since Social Security will likely play a major role in your retirement plan, it is especially true here.
Clear as mud, right? I know. There are a LOT of steps involved, with a lot of funny words and acronyms. Let’s give a quick recap.
- Make sure you either already have, or will have by the time you retire, 40 Social Security Credits so that you are eligible to receive Social Security retirement benefits from your own earnings record.
- Get your actual earnings history from your Social Security statement by logging into your my Social Security account online.
- Index your earnings by using this page from the Social Security website and typing in your Year of Eligibility (the year you turn age 62).
- Find your highest 35 years of indexed earnings (leave zeros if you have less than 35 years of work), add them together, and divide by 420 (35 years x 12 months = 420) to get your Average Indexed Monthly Earnings (AIME).
- Find your Full Retirement Age (FRA) from either looking at your Social Security statement again, or by using this calculator from the Social Security website.
- Find the correct bend points for your Year of Eligibility.
- Apply the Primary Insurance Amount (PIA) formula with the correct bend points to your AIME to calculate your PIA. This gives you your PIA as of your date of eligibility, also known as your “Raw PIA.”
- Apply a Cost of Living Adjustment (COLA) to your Raw PIA for each year between your Year of Eligibility and the year you reach your FRA. Then round this down to the next lowest whole dollar. This will give you your estimated PIA, which is the estimated Social Security retirement benefit amount, you will receive if you claim your benefit at your FRA.
- Adjust your PIA from future dollars to today’s dollars using the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). Again I recommend using the same/similar assumptions from the Trustees Report’s intermediate assumptions.
Comparing Your Results to Your Social Security Statement
You may notice that your results don’t match the results shown on your Social Security statement. That’s okay. The numbers that appear on your Social Security statement make 3 big assumptions.
- Constant Income: As we discussed earlier, your statement assumes your income stays exactly the same in the future. You may go part time or your income may fluctuate for a number of other reasons.
- Work Up Until the Date You Claim: Your statement assumes that you file for benefits immediately after you retire. Instead, you may retire and then wait to file for your benefits months or even years later.
- Zero Economic Growth: Lastly, your statement also assumes zero growth in the CPI-W and zero growth in the National Average Wage Index. These are critical for calculating increases in the Contribution and Benefits Base, Bend Points, and COLAs. This is an oversimplification that doesn’t even match what the Trustee’s Report estimates.
Other Tools Available
So how can you do better than just relying on your Social Security statement? Of course you can calculate your benefit yourself, but that’s tedious. This article walks through each step, but I intended it more for understanding and don’t expect you to do it regularly. There are some other options though.
- Social Security Online Calculator: This online calculator is free and gives you slightly more customization with regards to future income than your Social Security statement. But aside from that, it still assumes to future wage growth.
- Social Security Detailed Calculator: This downloadable calculator is also free, and is the most comprehensive tool the SSA offers. It only works on PCs (not Macs), and has an awful user interface, but is extremely accurate. I personally love this calculator because it is very transparent, showing each calculation and assumption step-by-step.
- Paid Tools: The best option is to purchase one of the many paid tools out there. The good ones not only calculate the numbers accurately, but also help you compare filing ages and different life expectancies. Personally I have used Maximize My Social Security, but there are plenty others to choose from.
What Can Throw Your Projections Off
Neither you nor the SSA, nor any other tool has a crystal ball. So any predictions about the future are just that: predictions. They can provide an estimate, and can be useful for planning purposes, but make sure to revisit your assumptions regularly. The SSA knows this, and even mentions it on your statement.
- Filing for Benefits Early/Late: The calculations listed above are solely to find your PIA. That is the amount of SS benefits you’ll receive if you file at your FRA. However, you can file for SS retirement benefits as early as age 62, or as late as age 70. Filing for benefits early/late will decrease/increase your benefit according to these rules.
- If you do want to calculate your benefit for filing early/late follow these additional steps:
- Calculate your Raw PIA.
- Factor in COLAs for your Raw PIA for the years from your Year of Eligibility up to the year in which you file for benefits to find your PIA at benefit date.
- Then apply the monthly increase/decrease.
- If you do want to calculate your benefit for filing early/late follow these additional steps:
- Incorrect Projections of Wage Growth/Inflation: Some of the steps listed above rely on predictions of future inflation and wage growth. I default to using the intermediate assumptions proposed in the Trustees Report, but these may be incorrect. Only time will tell.
- Other SS Benefits like Spousal/Survivors: The calculations listed above are solely to find your SS benefit from your own earnings record. Many retirees instead receive benefits from their spouse’s earnings record (Spousal Benefits), or their deceased spouse’s earnings record (Survivor Benefits).
- WEP/GPO: Your SS retirement benefit may be reduced if you worked for a company that didn’t withhold OASDI taxes and for which you receive a pension. This is called the Windfall Elimination Provision (WEP). Alternatively, if your spouse is receiving Spousal Benefits, they can also be reduced because of the Government Pension Offset (GPO).
- Maximum Family Benefits: If a family member, other than yourself, is receiving SS benefits from your earnings record, you may be subject to the Maximum Family Benefits (MFB) rules.
- Medicare Premiums: If you are enrolled in Medicare, some/all of your Medicare premiums may be automatically deducted from your Social Security benefit. This can reduce the amount of money that actually lands in your bank account.
- Income Tax Withholding: You can opt to have income tax automatically withheld from your Social Security benefits. Again, this will reduce the amount that actually lands in your bank account.
- Overall Reduction in Benefits: If no changes are made, Social Security benefits may get cut by about 24% across the board. Of course, this would have a significant impact on your projections.
Social Security is a huge part of most American’s retirement plans. Regardless of when you decide to claim your SS benefits, the size of your benefit all starts with your Primary Insurance Amount (PIA). That’s why having a good understanding of how your PIA is calculated is so important.
Knowing the ins and outs can also help you project how much Social Security you’ll receive in retirement more accurately than what you see on your Social Security statement.