What You Don't Know About Social Security Could Cost You

Social Security is America's most popular "retirement plan" by far, but it's poorly understood by millions of Americans -- especially those who are yet to claim their benefit. To help you make smart Social Security decisions for you and your family, here's a quick guide to how your Social Security retirement benefit will be calculated, how your retirement age affects your benefit, and whether or not your spouse may be entitled to a higher benefit than they think.

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How Social Security is calculated

Unlike most pensions, Social Security benefits aren't based on your last few years of earnings. Instead, the Social Security benefit formula takes all of your earnings into account.

Each year's earnings, up to the maximum amount that's subject to Social Security taxes, are indexed to account for inflation. Then, the 35 highest-income years are averaged together and divided by 12 to arrive at your average indexed monthly earnings (AIME). If you didn't have taxable earnings for at least 35 years, then a zero will be factored into the average for every missing year, so if you're close to 35 years of work but not there yet, then it may be worth it to work until you reach that milestone before you claim your benefit.

Once your AIME is determined, it is applied to a formula to determine your primary insurance amount (PIA), which is the Social Security benefit you'll receive if you claim it at your full retirement age. As of 2017, here's the formula for calculating your PIA:

  • 90% of the first $885
  • 32% of the amount above $885, up to $5,336
  • 15% of the amount above $5,336

This whole process may sound too complicated to attempt on your own, but fortunately, you can get a good estimate of what your Social Security benefit might be by creating an account at www.ssa.govand viewing your latest Social Security statement.

The effects of early or late retirement

Full retirement age for Social Security is 66 years old for individuals born in 1954 or earlier. Beginning with people born in 1955, two months is added to the full retirement age per year until it reaches 67 for those born in 1960 or later.

While full, or normal, retirement age is a specific number, you can choose to claim your Social Security retirement benefit as early as age 62 or as late as age 70. If you claim early, your benefit will be permanently reduced, and if you wait, your benefit will be permanently increased according to these percentages:

  • Your benefit will be reduced by 6-2/3% per year (5/9% per month) for up to 36 months before your full retirement age.
  • Beyond 36 months early, your benefit will be further reduced by 5% per year (5/12% per month), until as early as age 62.
  • If you delay Social Security beyond your full retirement age, your benefit will be increased by 8% per year (2/3% per month) until you reach age 70, when your benefit maxes out.

Aside from the financial implications, there are some potentially good reasons to claim earlyorlate, as well as on time. For example, if you're forced to retire earlier than you wanted, it may be a good idea to claim at 62 so you can pay the bills. On the other hand, if you're happy at your job and don't really need the money yet, it may be smart to wait. It's important to weigh the pros and cons of all your options, as well as to know what it will mean for the size of your monthly checks, before you decide.

How spousal benefits work

Social Security spousal benefits are not well understood by many people.

The simple explanation of spousal benefits is that your spouse is entitled to a retirement benefit equal to half of yours. This can be especially helpful if your spouse never worked or earned relatively little throughout their career, and is therefore entitled to little or no benefit based on their own earnings record. If their calculated benefit at full retirement age is less than half of your full retirement benefit, then a spousal benefit will make up the difference.

For example, if your full retirement benefit is $1,600 and your spouse is only entitled to a monthly benefit of $500 based on their work record, a spousal benefit of $300 per month will be added to theirs to make it equal to half of yours.

Spousal benefits can be reduced by early retirement, much like an individual's own benefits. For instance, if you claim benefits at age 62, then spousal benefits based on your record will be permanently reduced.

However, there is no such thing as delayed-retirement credits for spousal benefits. In other words, if your spouse's full retirement age is 67, they get no added benefit for waiting to claim spousal benefits beyond that age. Furthermore, one of the conditions for a spousal benefit is that the primary earner must also be collecting benefits. For this reason, if your spouse expects a benefit based on your work record, it is rarely a good idea to delay your benefit beyond their full retirement age, even if your benefit will continue to rise by doing so.

Social Security is not intended to be your only income source

As a final thought -- and this is particularly important for younger workers to understand -- Social Security is not meant to be your only retirement plan. Far from it, actually.

In fact, Social Security is only intended to replace about 40% of the average worker's pre-retirement income. Experts generally suggest that you plan to replace at least 80% of your income after retirement to maintain your standard of living, which means that you can rely on Social Security for at most half of your income in retirement. The rest will need to come from other sources, such as a pension or your own retirement savings.

With that in mind, if you have a 401(k) or similar retirement plan at work, it may be a good idea to boost your contributions. If you don't have an employer-sponsored plan, or if you just want to take a more proactive approach to your retirement investing, then check out The Motley Fool's IRA center, which can help you start building a nest egg of your own to complement your Social Security income.

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