How Social Security benefits are calculated

Experts often say that the foundation of a retirement plan is like a three-legged stool, with the legs of the stool being Social Security, employer-sponsored retirement benefits and personal savings.

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Social Security benefits will be a big portion of monthly retirement income for many Americans, and it helps to know how the benefits are calculated.

The first step is to determine whether you are entitled to Social Security benefits. To qualify for your full benefit, you must have accrued a certain number of credits. If you were born after Jan. 2, 1929, you need 40 credits (or 10 years of work) to receive your full retirement benefit.

In 2019, you must earn $1,360 to get one credit. You may earn up to four credits per calendar year. You must earn $5,440 to get the full four credits.

“If you are self-employed, you earn Social Security credits the same way employees do,” says certified financial planner Alexey Bulankov, vice president and portfolio manager at Mechanics Bank Wealth Management in the San Francisco Bay area.

The amount you would receive at your full retirement age, which ranges from age 65 to 67, depending on the year you were born, is called the primary insurance amount, or PIA.

The not-so-secret formula

The formula for calculating your PIA is based on the average indexed monthly earnings, or AIME, in the 35 highest-earning years after age 21, up to the Social Security wage base. In 2019, the base is $132,900, an increase of $4,500 from last year. The wage base is the maximum amount of income on which Social Security taxes must be paid.

“If a person works (fewer) than 35 years, missing years are filled in with zeros. If they have worked more than 35 years, only the highest-earning years will be considered,” says Charles C. Scott, founder and president of Pelleton Capital Management, a financial services firm in Scottsdale, Arizona.

Earnings from a worker’s 35 highest-earning years are tallied at age 62 and indexed for inflation, resulting in the AIME, Bulankov says.

The AIME is “divided into three segments, called bend points (which are adjusted each year for inflation), giving you the worker’s PIA,” says Scott.

For example, a 62-year-old born in 1957 whose total indexed earnings over her 35 highest-earning years were $2.5 million would have an AIME of $5,952.38 ($2,500,000 / 420 work months = $5,952.38).

The first bend point, $926 of the AIME, is multiplied by 90 percent. The difference between $926 and the second bend point of $5,583 ($4,657) is multiplied by 32 percent. The AIME is greater than the second bend point, so that difference ($369.38) is multiplied by 15 percent, giving you the third bend point.

Now, let’s apply this formula to figure out what the Social Security benefit would be for our worker with an AIME of $5,952.38.

  • The first bend point gives her a benefit of $833.40 ($926 x 0.9 = $833.40)
  • The second bend point gives her a benefit of $1,490.24 ($4,657 x 0.32 = $1,490.24)
  • The third bend point gives her a benefit of $55.40 ($369.38 x 0.15 = $55.40)

The sum of these three amounts is $2,379.04. Benefit amounts are rounded down to the next-lowest dime, so this worker’s PIA, which is the amount she would receive if she waits until her full retirement age (66 + 6 months) to collect Social Security, is $2,379.

Bend points and formulas are set annually by the Social Security Administration.

Stay on top of your benefits

Certain factors can change the amount to which you are entitled, such as electing to receive benefits before full retirement age or delaying benefits past the full retirement age. Government workers receiving pension benefits may not be eligible to receive Social Security.

You get a reduced benefit if you claim benefits early, and you get a higher benefit if you delay claiming benefits up to age 70.

“Claiming Social Security early results in a permanent pay cut from what your benefit would be at full retirement age,” warns Greg McBride, CFA, Bankrate’s chief financial analyst.

“Better still is that each year you delay Social Security after your full retirement age and up until age 70 results in an 8 percent increase — a permanent pay raise, if you will, above the benefit you’d have received at full retirement age,” McBride says.

Social Security calculations can be complicated, but understanding how your benefit is determined can help you plan for retirement.

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You also can estimate your benefits by using the SSA’s Social Security Retirement Estimator. It’s a good idea to go to the SSA website and create an account so you can get your Social Security statement online. Go to www.socialsecurity.gov/myaccount to review your statement.

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