The Simple Math Behind Social Security
Ever wonder how social security is calculated? It’s not just an academic exercise. Understanding how the Social Security Administration calculates your retirement benefits can help you maximize your monthly check.
I have exactly one friend who enjoys talking about money — you know, who actually likes discussing 401(k)s, saving rates, and taxes.
Well, she recently brought up the topic of Social Security because her father is 62 and was thinking about filing. I asked her, “Why would he do that?” Her response: “Because he can.”
Her father is an intelligent, successful doctor who still practices medicine several days a week. I thought to myself, “Surely, if I could just help him understand the way Social Security is calculated, he will change his strategy.” And he did! Once he understood the process, he wanted to optimize his check. For him, that meant waiting.
You can understand, too. I’ve described below the basic steps used to determine your benefit. The plan you have now might not be the best plan for your bank account.
1. Every year of earnings is calculated to represent present value
Social Security does this for your benefit, actually. The present value calculation neutralizes the effects of both wage growth and inflation.
Earning $10,000 in 1982 is like earning $25,751 in 2017. Social Security adjusts every year of your earnings to the equivalent value in the year you file. The later you can wait to file, the more likely it is that your benefits will be higher.
2. Your highest 35 years of income are averaged to determine your Average Indexed Monthly Earnings (AIME)
Social Security includes zeros in your average if you worked less than 35 years. Every year you work, your AIME will be recalculated—a high income year will replace a low income year, or a no income year.
If you are currently in your peak earnings, working a few extra years could make a big difference in your benefit.
3. Social Security will apply its own algorithm using your AIME to determine your monthly retirement benefit, or Primary Insurance Amount (PIA)
Social Security uses a complicated calculation. There is no need to compute it on your own. You can create an account with My Social Security to monitor your earnings record and view estimated monthly benefits.
4. Full Retirement Age
Your monthly benefit is adjusted based on the age you choose to retire. It increases if you wait until after your full retirement age and decreases if you file early. Social Security determines your full retirement age on a sliding scale based on the month and year you were born. For most people retiring soon, this is approximately 67 years old.
When Social Security calculates your monthly benefit, they assume you are going to file as soon as you hit your full retirement age. However, you get to choose your filing date. The earliest age you can collect standard social security benefits is 62.
Filing Early
Let’s say that you are someone born in 1960 who has averaged a salary of $60,000 a year. When you hit your full retirement age in the coming years, you’ll receive a Social Security benefit of $2,007 per month.
Social Security reduces your benefit for every month you collect before your full retirement age. For someone born in 1960 and averaging $60,000 a year in earnings, collecting social security at age 62 results in a monthly benefit of $1,403 compared to $2,007, approximately a 30% reduction.
Filing Late
In contrast, Social Security increases your benefit for every month after full retirement age you delay filing. In the example above, if you wait until age 70, you would receive $2,483 compared to $2,007, approximately a 24% increase. But don’t wait until after age 70 because your monthly benefits stop increasing after that age.
Delaying Social Security for a few years can make a big difference over time, especially if you or your dependent spouse plan to live a long time.
Other Factors
This is not straightforward stuff. The steps above cover basic computations, though many other factors should influence your decision for when to file. For example, you should consider these factors:
- Your overall tax situation
- If you are working or earning income before full retirement age
- Your immediate cash flow needs
- If you have dependents that may qualify for family or survivor benefits
- Your health and longevity
- Your spouse’s health and longevity
- If you have a spouse or divorced spouse who is a high income earner
When it comes to Social Security, the devil is in the details, and it is nuanced for every situation. And you want to get it right because you only get to file once (well, twice if you include the do-over provision).
To ensure you are filing at the best time for your situation, it’s a good idea to speak with a retirement professional, contact the Social Security office, AND keep learning on your own.
Article comments
The article didn’t seem to address the break even point of collecting early vs. waiting. Sure, you get a reduced benefit at 62 vs. 70, but you also have collected the reduced benefit for 8 more years. When I ran the annual benefit at 62 vs. 70, you’d have to live to 88 to break even (i.e., the cumulative benefit received from waiting until age 70 doesn’t exceed the cumulative benefit received from starting at age 62 until you reach age 88).
I may not have done the analysis correctly, so appreciate other’s feedback.
Correction: The breakeven for taking at FRA is 88. Waiting until 70 reduces it to about age 80.
Correction #2: FRA breaks even at 78, not 88.
Michelle Dash: Would you comment on when social security should be taken when the recipients do not need the money. My wife and I have a modest income but will not need social security income when we retire when I am 63-64 years old; my wife is two years younger than me. We will be taxed on 85% of our social security. When would you advise us to begin claiming and what factors are you using in your analysis?
Thanks, Rick