How Your Retirement Benefit is determined
The main component of Social Security is the retirement benefit paid to workers after they reach age 62. Your retirement benefit is based on how long you worked and how much you earned in total wages.
This video describes how your Social Security retirement benefit is calculated.
How Long You Worked
In order to be eligible for Social Security retirement benefits, you must have accumulated at least 40 Social Security credits. You receive one credit for employment income you receive that is at or above a minimum dollar amount, and you can earn up to four credits per year.
For example, in 2014, the minimum income needed for retirement credit was $1,200. So if Fred earned at least $1,200 in wages that year, he earned one credit for the year. It doesn’t matter when during the year he received it, whether it was in one lump sum or spread out throughout the year. If he earned at least $2,400 in 2014, he received two credits, and so on up to a maximum of four credits.
The amount needed for retirement credit is adjusted periodically for inflation. Click this link to find out the current minimum income needed to earn retirement credit.
You must earn at least 40 total credits over your working life in order to be eligible for Social Security retirement benefits. Since you can earn up to four credits per year, this means you must work at least 10 years. Once you have accumulated at least 40 credits, you are “fully covered” under Social Security and can receive benefits when you reach eligibility age of 62. Once earned, credits stay on your record, even if you leave the workforce or stop working for a while.
Over your working life, you likely will earn much more than needed to accumulate 40 credits. This excess does not increase your retirement benefit. The amount of your benefit is based on how much you earned during your working life.
How Much You Earned
Assuming you have the required number of credits and are fully covered, your retirement benefits are calculated by a three-part formula.
First, Social Security totals your earnings over the 35 years of your working life in which your income was highest. The Social Security Administration (SSA), which administers the program, keeps a record of your earnings each year from age 16 on. Earnings from age 16 to age 60 are indexed based on historic wage growth; earnings after age 60 are not. The SSA uses the average wage index to index earnings.
So if you’re now 65 and applying for benefits, Social Security looks up your wages each year from age 16 to age 60, indexes those based on historic wage growth, and also looks up your wages each year from age 60 on. It then picks out the 35 years in which your earnings were highest.
Again, if you’re a high-earner, a maximum dollar amount applies when calculating your benefit. Only your income up to this amount each year is applied toward your benefit.
For example, in 2014, the annual limit was $117,000. If a worker earned more than that amount in 2014, only $117,000 is used in calculating Social Security benefits.
If you have fewer than 35 years of employment, then the formula puts in your wages for the years you did work, and puts zeroes for the years you were not working.
Your total income for the 35 years with the highest earnings is divided by 420 (number of months in 35 years) to get your Average Indexed Monthly Earnings, or AIME.
For example, if Fred earned $60,000 per year for 35 years, his total earnings were $2,100,000 and his AIME is ($2,100,000 / 420) = $5,000.
The next part of the formula is where Social Security is tilted in favor of lower income workers. The formula calculates three different percentages of your AIME. A larger percentage of earnings are included up to a certain dollar amount, and smaller percentages are included of earnings above this amount.
In 2014, the percentages and dollar amounts were as follows:
(90% of your first $816 of AIME) + (32% of AIME above $816 and through $4,917) + (15% of AIME above $4,917)
The sum is your estimated monthly retirement benefit at your full retirement age.
The dollar amounts at which the percentage changes are called bend points. The bend points are adjusted annually with inflation. Click here to find the bend points for the current year.
If Fred’s AIME is $5,000, his benefit is calculated as follows:
90% x $816 = $734.40
+ 32% x ($4,917 – $816) = $1,312.32
+ 15% x ($5,000 AIME – $4,917) = $12.45
Total monthly benefit = $2,059.17
This is Fred’s basic monthly Social Security retirement benefit, also called the Primary Insurance Amount (PIA).
The monthly amount calculated in Part 2 is what you will get if you start receiving benefits at your full retirement age. Your full retirement age varies depending on the year you were born. It’s 65 if you were born in 1937 or earlier, and increases incrementally to 67 if you were born in 1960 or later.
Click this link to find out your full retirement age based on the year you were born.
You don’t have to start receiving benefits at your full retirement age. You can choose start taking benefits as early as age 62, or as late as age 70. However, your monthly benefit will be permanently reduced if you start receiving payments before your full retirement age, and permanently increased if you delay until after your full retirement age.
The final part of the formula applies if you choose to start taking Social Security benefits either before or after you reach your full retirement age. A reduction to your benefit is applied to your PIA if you begin benefits before your FRA, and a credit is applied if you begin receiving benefits after your FRA.
Early Retirement Reduction – if you start receiving benefits before your FRA
If you start taking benefits before you reach FRA, your monthly payment will be lower than the PIA calculated in Part 2. The reduction is:
So if you elect to start receiving payments two years (24 months) before your FRA, your benefit will be reduced by 5/9 x 1% x 24 = 13.33%
If Fred’s full monthly benefit would be $2,000, but he chooses to start receiving it two years before his FRA, his benefit would be reduced to $1,733.
So if you elect to start receiving payments four years (48 months) before your FRA, your benefit will be reduced by
5/9 x 1% x 36 = 20%
for the 36 months you are below FRA, plus an additional 5/12 x 1% x 12 = 5% for the additional 12 months. Your total reduction will be
(5/9 x 1% x 36) + (5/12 x 1% x 12) = 25%
So if Fred’s FRA is 66, and he starts receiving payments at age 62, his $2,000 benefit would be reduced to $1,500.
The most your monthly payment could be reduced by is 30%. This will happen if your FRA is 67, and you start receiving payments five years earlier, at age 62.
Late Retirement Credit – if you start receiving benefits after your FRA
If you delay taking benefits until after your FRA, your monthly payment will be higher than if you started receiving it at FRA.
Your monthly payment is increased by 5.5% to 8% for each year you are above your FRA when you start taking benefits, depending on what year you were born. Click this link to see what the increase is for your birth year. The credit only applies until you reach age 70. After that, there is no further credit for delaying benefits.
So if your FRA is 66, and you elect to start receiving benefits at age 70, your payment will be increased by 8% x 4 = 32%. If your PIA is $2,000, your benefit starting at age 70 would be $2,640.
Reduction for working while receiving benefits
You can continue to work while receiving Social Security retirement benefits. However, if you are below your full retirement age, you have to defer some of your benefits until you reach FRA.
If you have reached your FRA, your earned income does not affect your Social Security payments, regardless of how much you earn.
If you are below your FRA, and your income for the year exceeds a certain dollar limit, your benefit payment is reduced. Your Social Security benefits are reduced by $1 for every $2 that your earnings are above this limit. In 2015 and 2016, the limit was $15,720. The limit is adjusted periodically. Click this link to see the current limit on annual earnings.
During the calendar year that you will reach FRA, a different earnings test is applied. Under this test the limit is raised (to $41,880 in 2015), and the reduction is $1 for every $3 above this amount. Furthermore, only earnings in the months prior to reaching NRA are counted. Earnings during the month you reach retirement age aren’t included in the test.
If your income is sufficiently high, your retirement benefit might be reduced to zero under the benefit. However, reductions in your benefit are temporary. When you reach FRA, your benefits are no longer reduced.
Furthermore, any months in which you didn’t receive benefits will be treated as increasing the age at which you claimed Social Security, which in turn will increase your future benefit amount once you reach FRA. For example, suppose you claimed Social Security a year before FRA, but didn’t receive benefits because of the earnings test. When you reach FRA, the Social Security Administration calculates your benefits as though you applied for benefits at FRA instead of a year early.
You can use the SSA’s retirement earnings test calculator to find out how much of your benefit will be deferred if you’re below your FRA and working.
Two other ways your benefits can be reduced
There are two provisions in the Social Security laws that will reduce your benefits if they apply to you.
Windfall Elimination Provision
This may apply if you receive a pension from a previous employer and Social Security taxes were not taken out of your pay while you worked there. This situation most commonly occurs with employees of state and local governments and American employees of foreign companies.
Remember that your Social Security benefits are calculated based on 90% of your earnings up to a certain dollar amount. What the WEP does is reduce that 90% to a lower percentage, which could be as low as 40%. This can make a huge difference in benefits. For example, someone whose benefits would have been $1,615 per month could have their benefit reduced to $202 per month.
The amount of reduction depends on how many years of earnings you had at an employer in which Social Security taxes were taken out of your pay. If you worked for at least 30 years at an employer in which Social Security taxes were taken out, then the 90% multiplier is unchanged. If you worked for 29 years at this employer, the percentage is lowered to 85%; if you worked for 28 years, the percentage is 80%, etc. If you have 20 or fewer years of work where Social Security taxes were taken out, the percentage is 40%.
The WEP does not apply to benefits paid to your spouse and family members based on your earnings. Their survivor benefits are not affected.
The SSA has a calculator that helps you determine whether the WEP could affect your benefits.
Government Pension Offset
A provision that could affect your Social Security spouse’s or widow’s or widower’s benefits is the Government Pension Offset. The GPO affects you if you receive a pension from federal, state, or local government based on work in which you did not pay Social Security taxes. An amount equal to two-thirds of your pension is deducted from your Social Security spouse’s or widow’s or widower’s benefits. For example, if you receive a monthly pension of $600, then $400 is deducted from your benefits. If your benefits are $500, then the GPO reduces your benefits to $100.
Social Security spouse’s or widow’s or widower’s benefits are intended to compensate spouses who stayed home to raise a family and are financially dependent on the working spouse. But if the stay-at-home spouse also receives their own retirement benefit, for example based on parttime work, their Social Security spouse’s or widow’s or widower’s benefits are reduced by an equal amount.
The SSA has a calculator that helps you determine whether the GPO could affect your benefits.
Calculating your benefits
This quick calculator from the SSA gives you an estimate of what your Social Security benefits will be, based on your earnings history and age.
If you want a more exact calculation, you can use this detailed calculator to get a personalized estimate, based on the SSA’s records.
You can also view your Social Security benefits statement online anytime by creating an account at My Social Security.
Taxes and Social Security
Social Security benefits are taxable for many people. Your benefits are taxable if your “base income” exceeds certain minimum levels. Your base income consists of:
(half of your Social Security benefits +
your Adjusted Gross Income from other sources +
Why half of your Social Security benefit? The thinking is that during your working life, you and your employer contributed equally toward your Social Security benefit. So half of what you receive is considered a return of principal.
The levels that trigger Social Security taxes are $25,000 for a single person and $32,000 for married couples filing jointly. If your base income is below this level, your Social Security benefits are not taxable at the federal level. If your base income is between $25,000 and $34,000 for an individual, or between $32,000 and $44,000 for a married couple then 50% of your social security retirement benefits are taxable. For base income amounts above $34,000 for singles, or $44,000 for couples, Social Security benefits are 85% taxable. The benefits are taxed at ordinary income tax rates.
The taxation of Social Security benefits triggered by high base income is known as the “tax torpedo”. There has been much research and advice about how to avoid it. Some recommend avoiding taking Social Security and IRA distributions at the same time. The reasoning is that the combination of Social Security and other income will possibly push you above the threshold where Social Security becomes taxable.
But this strategy doesn’t work out in all cases. For example, suppose you decide your income needs are $48,000 per year (before taxes). You take Social Security at age 62, with a benefit of $24,000 per year, and supplement it with IRA distributions of $24,000 per year. Your base income is then $36,000 per year ($12,000 + $24,000). This is above the $32,000 individual threshold, so 85% of your Social Security benefit is taxable. Assuming a 25% tax rate, your take-home benefit is $15,300.
On the other hand if you waited until age 70 to claim Social Security, your benefit is $39,360. If you supplement this with $8,640 of IRA distributions, your base income then is $28,320 ($19,680 + $8,640). In this case, 50% of your benefit is taxable, so your take-home benefit is $14,760, lower than in the previous case.
The bottom line is that the best strategy is determined on a case-by-case basis. You will have to determine what works best for your situation. Taxes are just one consideration of when to take Social Security and IRA distributions.
The next page describes some common strategies for maximizing your Social Security retirement benefits.