Social Security Room

Photo: FDR Presidential Library and Museum via Flickr.

This article was last updated on May 5th, 2016.

Social Security is an important part of most Americans' retirement planning, so it's important to know how it works and how you can estimate your Social Security benefits. You should also understand your Social Security eligibility and how taking Social Security benefits before, at, or after full retirement age can affect your retirement income.

How your Social Security benefit is calculated
Unlike many pension plans, which are based on just the top few years of your earnings, Social Security takes your 35 highest-earning years into account when computing your benefit. Each year's income, up to the maximum taxable Social Security wages, is indexed for inflation, and averaged together. A formula is then applied to arrive at your full Social Security benefit -- that is, the monthly amount you are entitled to if you retire at your full retirement age.

Once your average indexed monthly earnings are calculated, if your first year of eligibility is 2016, your benefit is calculated as:

  • 90% of the first $856 in monthly earnings
  • 32% of the amount between $856 and $5,157
  • 15% of the amount above $5,157

As an example, let's say that your average indexed monthly earnings were $4,000. Based on the formula, your benefit would be 90% of $856, or $770.40, and 32% of the other $3,144, or $1,006.08. Adding these together produces a monthly benefit of $1,776.48.

Are you eligible for Social Security?
In order to be eligible for Social Security, you need to earn 40 "credits" during your working lifetime. Each $1,260 in earnings you have in 2016 will give you one credit, up to a maximum of four credits per year. This amount changes each year, but if you earn enough to get the four-credit maximum in each of 10 years, you'll be eligible for Social Security benefits.

Your eligibility status is reflected on your annual Social Security statement, which I'll discuss a little later.

What is your full retirement age?
For people born between 1943 and 1954 (those reaching retirement age now), full retirement age is 66 years old. For those born after that time period, the full (or normal) retirement age gradually increases to 67 for those born in 1960 or later.

Here's a chart to help you determine your full retirement age for Social Security.

If you were born in...

Your full (normal) retirement age is...

1943-1954

66 years

1955

66 years, 2 months

1956

66 years, 4 months

1957

66 years, 6 months

1958

66 years, 8 months

1959

66 years, 10 months

1960 or later

67 years

Your full retirement age is useful to know, because your calculated Social Security benefit amount from the previous section (also known as the primary insurance amount) assumes you start collecting benefits at this age exactly.

Filing early or late can make a big difference
You don't have to wait until full retirement age to start collecting benefits. In fact, you can file for Social Security as early as age 62, or you can choose to delay your benefits until age 70.

If you file early, your benefit will be reduced. Starting with your full benefit amount, your benefit is reduced by 6-2/3% for each year before full retirement age (up to three years early), and 5% for each year beyond that. Conversely, if you choose to delay benefits, your monthly checks will increase by 8% for each year you decide to wait.

To illustrate this, here's how your benefit could be affected if your full retirement age is 66.

If you start collecting benefits at this age

Your benefit will be (% of full retirement age benefit amount)

62

75%

63

80%

64

86.7%

65

93.3%

66

100%

67

108%

68

116%

69

124%

70

132%

How to estimate your benefits before you retire
You can obtain your Social Security statement by creating an account at www.ssa.gov. Your statement contains lots of valuable information, such as

  • Your estimated benefit amount at full retirement age.
  • Eligibility for benefits.
  • A detailed history of how much you've earned each year.
  • Estimates for disability and survivors' benefits, should you need them.

Ss Screenshot

Keep in mind that the figures in your statement are just estimates, and your eventual benefit amount could be quite different, especially if you're relatively young now.

Benefits are protected from inflation
While Social Security isn't designed to be anyone's sole source of retirement income, it is indexed for inflation – meaning unlike most other retirement assets, your purchasing power will remain the same over time.

Each year, the Social Security Administration (SSA) applies a cost-of-living adjustment to Social Security benefits, based on the consumer price index. The index that the SSA uses actually fell during its 2015 measuring period compared to the previous year, so there will be no cost-of-living adjustment in 2016; but there have been some substantial adjustments in the past. In 1980, inflation was so high that Social Security recipients received a 14.3% cost-of-living adjustment to keep up.

The point here is that you don't need to worry about inflation -- at least when it comes to your Social Security income. The system is designed so that, if goods and services eventually cost twice as much as they do today, you'll receive double the Social Security.

How to file for Social Security
The easiest way to apply for Social Security benefits is online at ssa.gov. The application takes about 15 minutes, according to the SSA, and there are no additional forms to sign, and usually are no additional documentation requirements.

If you don't want to apply online, you do have other options. You can apply by phone from 7 AM to 7 PM, Monday through Friday, or in person at your local Social Security office. If you choose to apply in person, the SSA advises that you should make an appointment. You can look up the SS office closest to you here.

Spousal, disability, and survivors' benefits
There's more to Social Security than retirement benefits. In fact, there are three other types of Social Security benefits to be aware of:

  • Spousal benefits: If you and your spouse both file for Social Security at full retirement age, each spouse is guaranteed a minimum of half of the other's benefit. For example, if a retiree is entitled to a monthly benefit of $2,000, their spouse will receive at least $1,000, even if his or her own benefit amount would be much less according to their work record.
  • Survivors' benefits: If a worker dies, his widow, children, and other dependents could be eligible for benefits. Survivors benefits are an entire topic by themselves, so here's a full discussion of this feature of Social Security.
  • Disability benefits: If you become disabled and can no longer work, your Social Security record could entitle you to benefits. You can find your theoretical disability benefit amount on your Social Security statement, as you can see in the example above.

Can you work and collect Social Security at the same time in 2016?
Sort of. There are three different categories of Social Security recipients, and there is a different "earnings test" that applies to each.

  • For SS recipients who will not yet reach full retirement age in the 2016 calendar year, the first $15,720 in earnings is exempt. Beyond that amount, every $2 in earnings will reduce Social Security benefits by $1.
  • For SS recipients who will attain full retirement age during 2016, the first $41,880 is exempt, and the reduction is just $1 for every $3 in earnings beyond that. Plus, only the months before your birthday count toward the total.
  • Finally, SS recipients who choose to work past full retirement age will experience no benefit reduction, no matter how much they earn.

It's also important to note that any reduction in benefits isn't lost -- rather, a reduction will increase your future benefit amount. For a thorough description of the rules about working and collecting Social Security, check out this article.

Isn't Social Security going bankrupt?
While it's true that, within a few years, money will begin flowing out of Social Security's trust funds faster than it's flowing in, it shouldn't be cause for concern. Even without congressional action, Social Security will be able to cover 100% of benefits until 2033. After that, once the trust funds are depleted, the taxes coming in will still be enough to cover more than three-fourths of all benefits.

As I've written before, I'm confident that something will be done. Similar situations have come up in the past, and measures were taken to prolong the system's solvency.

It's a popular misconception that once the trust funds run out, benefits could stop coming altogether. Some retirees are even claiming benefits earlier than they otherwise would, fearing that they should get what they can while Social Security still has money to pay. Don't make this mistake.

A major financial decision
Even if you have substantial assets when you retire, chances are that Social Security will still make up a large portion of your retirement income. The decision of when to begin collecting Social Security is one that can affect you and your family for decades, and should be taken seriously. If you're approaching the age of eligibility, make sure to carefully consider all of the pros and cons before filing.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.