Overestimating your Social Security income can be catastrophic for your retirement plan. It's important to understand how your benefits are determined so that you can set reasonable expectations for guaranteed cash flow in retirement. It would be great to have $4,194 of monthly income, but most investors are better off getting this number out of their heads.
Expectations vs. reality
Obviously, the maximum benefit is going to be higher than the average, but the difference here is staggering. The average monthly Social Security check is under $1,700 right now. That's only 40% of the maximum.
For most people, the reality of retirement benefits will fall nowhere near the highest potential number. It's important to manage expectations with that in mind. People who go toward retirement expecting anything close to the maximum are probably setting themselves up for disaster.
With that in mind, investors should examine the Social Security benefit calculation so that they can accurately estimate their guaranteed retirement cash flows. That helps you determine how much you'll need to save in your personal investment accounts.
How Social Security is calculated
It's important to understand which factors actually go into the calculation of benefit amounts. There are a number of variables at play here, and we should consider all of them. First and foremost, the amount of benefit that is withdrawn is based upon the amount paid in.
Right now, the maximum individual taxable income for Social Security is $147,000. If you make that much each year, then you've maxed out the contribution. That's the number an individual earner needs to hit to be eligible for the maximum benefit.
Individual annual income of $147,000 represents the 92nd percentile in the United States. Obviously, most people are falling way short of that level. Median household income, which can include multiple earners, is under $67,000. That's not even halfway to the individual maximum.
The Social Security administration expects less than 20% of wage earners to exceed the taxable maximum at any point in their career. That's tough enough odds for people aspiring to the highest possible benefit. It's even more daunting when you consider the fact that you would have to defy those odds for 35 years. It's not good enough to max out contributions for one year, ten years, or even three decades -- retirement benefits are calculated based on your highest 35 yearly earnings.
Tons of things can disrupt that streak, even for the strongest earners. Lean years, transition years, launching a business, or retiring early can all reduce Social Security benefits -- sometimes drastically. Unless everything goes perfectly for more than three decades, then the maximum benefit is probably unattainable.
Full retirement age (FRA) is the age at which people are entitled to 100% of their Social Security benefit. FRA has risen over time, but it's currently 67 for people born after 1960. You can elect to begin receiving monthly checks at any age between 62 and 70. If you start at 62, your checks will be 30% lower. However, those checks can be 24% higher for people who delay collections until age 70.
Even people who are eligible for the maximum Social Security benefit can wind up settling for lower income. Nearly one-third of retirees start taking benefits at age 62. A huge portion of the population doesn't make it to FRA, contributing to the illusion of the max benefit.
Taxation is also something to consider, particularly if you're receiving the maximum monthly benefit. Individuals and married couples who are getting $4,194 checks each month exceed the threshold above which a portion of Social Security is eligible for federal income taxation. Adding in any additional income from investments, retirement account distributions, or pensions only exacerbates the issue.
There could also be an issue at the state level. Among the states that collect income tax, 13 of them don't exempt Social Security benefits from taxable income. Many of these states build in generous exemption limits, but, again, there's a strong chance that you're above those thresholds if you're receiving the maximum benefit. Even if you're taking in $4,194 each month, it's possible that the government will take a substantial cut before it hits your bank account.
Make sure that you set realistic expectations for Social Security benefits. it's an important piece of most retirement plans, and it's not something most of us can afford to get wrong.