If you are more than a few years away from retirement, it can be difficult to predict how much benefits you will receive from Social Security. But, knowing how what Social Security payments are based on can help you determine how much benefits you will receive when you retire.
Social Security payments are based on your work record, earnings history, claiming age, and birth year. When calculating Social Security benefits, Social Security takes your 35 highest-earning years; if you worked less than 35 years, Social Security includes $0 income for the years you did not work. You can claim benefits as early as age 62, at the full retirement age, or delay taking benefits until age 70.
What is Social Security based on?
The average Social Security check in 2023 is $1,827, while the maximum benefit you can receive at the full retirement age is $3,627, or $4,555 if you claim benefits at age 70. The huge variation in Social Security payments may be attributable to various factors.
Social Security payments are determined by the following factors:
Work history
Social Security considers your 35-highest earning inflation-adjusted years when calculating your benefits. If you worked more than 35 years, Social Security will take the highest-earning years, while the years will lower or zero earnings will be excluded. If you worked less than 35 years, $0 income years will be averaged into your earnings history.
If you are still working, you should aim to work for at least 35 years, and you should not stop there. Generally, most people earn more later in their careers, and the higher-earning years will replace the lower-earning years as you work.
Earnings history
For every year you work, you pay a Social Security tax on your income up to a certain limit. For 2023, the income limit is $160,200, up from $147,000 in 2022. If your income is below this income limit, you will pay Social Security taxes on your full income. But, if your income is higher than the income limit, you will pay Social Security taxes on part of your annual income.
Generally, higher earnings will result in higher Social Security benefits. However, the percentage of your pre-retirement pay that is replaced declines with the increase in income. At the full retirement age, Social Security will replace up to 75% of the pre-retirement income for low-earners, 40% for medium earners, and 27% for high-earners.
Claiming age
The age when you get the first Social Security check will determine how much benefits you receive. If you want to receive the full benefit, you should wait until you attain your full retirement age to claim benefits. The full retirement age falls between ages 66 and 67.
You can also claim benefits starting from age 62. However, your benefits will be permanently reduced by up to 30% if your full retirement age is age 67, or by up to 25% if your full retirement age is 66.
If you don’t need the benefits immediately, you can delay claiming benefits until age 70. Your benefits will increase by 124% and 132% if your full retirement age is 67 and 66 respectively.
Birth year
Social Security uses birth year to assign a full retirement age to eligible beneficiaries. Generally, the full retirement age falls between 66 and 67. You can use this Social Security chart to determine your full retirement age based on your year of birth.
How Social Security benefits are calculated
Social Security benefits are determined using the Average Indexed Monthly Earnings (AIME), which considers a worker’s 35 years of earnings. Social Security applies a formula to AIME to calculate the Primary Insurance Amount (PIA), which reflects the amount you are eligible to receive at the full retirement age.
AIME
When calculating an insured worker’s benefits, Social Security adjusts their historical earnings to reflect the change in general wages during their years of employment. The earnings are adjusted to reflect the rise in the standard of living during the worker’s lifetime.
Social Security uses a worker’s 35 years of earnings to calculate AIME. These earnings are tallied and indexed for inflation, then divided by the number of months in those years i.e. 35 x 12= 420. This yields the average indexed monthly earnings. AIME is divided into three components known as bend points, which give the worker’s PIA.
PIA
The PIA is the sum of the three components of the AIME. Here are the bend points for calculating PIA:
90% of the first $1,115 of AIME
32% of earnings between $1,115 and $6,721.
15% of earnings above $6,721.
The sum of the three percentages is the PIA, and it represents the benefits you would receive if you claim benefits at the full retirement age. The sliding scale is designed to help put low-income workers closer to their pre-retirement income level and prevent poverty in old age.
Practical example
Assume that John was born in 1966, and his inflation-adjusted earnings over his 35-highest earning years were $1,500,000. This means his AIME is $3,571 ($1,5M/420 work months). His AIME is subjected to the bend points to calculate his PIA:
90% x $1,115 = $1,003.50
32% x (3,571-$1,115) = $785.92
John’s earnings were below $6,721, so there is no benefit in the third component
The sum of these figures is $1,789.42, which is the PIA. Therefore, John would receive $1,789.42 at the full retirement age. But, if John decides to claim benefits at age 62, the benefits would reduce by as much as 30%.
How often does Social Security recalculate benefits?
Social Security recalculates benefits annually to account for cost-of-living adjustments (COLA) and changes in income and work. This means that your Social Security payments can change from year to year.
Cost of living adjustments
Social Security makes cost-of-living adjustments every year in October to account for increases in the cost of living. The COLA for 2023 was 8.7%, which increased Social Security benefits by $146 every month, effective January 2023.
Payment increase from continuing to work
Social Security calculates benefits based on a worker’s 35 highest-earning years, adjusted for inflation. If you continue working after you claim benefits, and you earn more than one of your previous 35 years of earnings, Social Security will recalculate your benefits to reflect the changes in earnings history.
Payments decrease from continuing to work
If you start taking Social Security checks before attaining the full retirement age, you will be subject to an income limit. If you earn more than the income limit, your Social Security payments will be reduced. For 2023, the income limit is $21,240. If you are receiving benefits and continuing to work, your benefits will be reduced by $1 for every $2 you earn above the annual income limit.
