Photo: 401kcalculator.org via Flickr.

The Windfall Elimination Provision is designed to prevent people who didn't pay Social Security tax on the majority of their income from receiving disproportionately high Social Security payments. In general, when you work for an employer in the United States, Social Security tax is taken out of your paycheck, but if you worked for government organizations or were employed by a foreign company, then this may not be the case.

Here's what you need to know about the Windfall Elimination Provision and whether or not it could apply to you.

The Windfall Elimination Provision
Essentially, the Windfall Elimination Provision can reduce Social Security benefits paid to individuals who receive a pension based on income from an employer that didn't withhold Social Security taxes. This is fairly common for government workers, as well as people who spent much of their lives working for foreign companies. Specifically, the provision applies if the individual's pension results from income that wasn't subject to Social Security tax, but also had income from other jobs that did have Social Security tax withheld.

To understand why the Windfall Elimination Provision is necessary, you must first understand how Social Security benefits are calculated.

Social Security is designed to benefit lower-income individuals more than higher-income ones. Essentially, your highest 35 years of Social Security-taxed earnings are indexed for inflation and then averaged to determine your lifetime average monthly earnings. Based on that amount, the following factors are applied to calculate your monthly benefit amount at full retirement age, also known as your primary insurance amount (PIA).

  • 90% of average monthly earnings up to $826
  • 32% of average monthly earnings from $826 to $4,980
  • 15% of average monthly earnings above $4,980

For example, if a worker's average monthly earnings for Social Security purposes were $1,500, he or she would be entitled to a monthly benefit of $959 per month, or 64% of their average earnings. However, another worker who averaged $4,000 per month would receive $1,759 per month, or just 44% of their average monthly earnings.

If an individual only paid Social Security taxes on a small portion of their income, their average monthly earnings would appear to be low and not reflective of the actual amount of money they earned -- which is the basis for the pension they receive. In other words, the Windfall Elimination Provision is designed to prevent individuals in this situation from receiving a "windfall" of Social Security benefits that are not proportional to the income they actually earned.

Will it affect you?
If you receive a pension based on earnings that weren't subject to Social Security tax, you could be subject to the Windfall Elimination Provision. Whether or not you'll be affected depends primarily on how much you earned from other employment that did have Social Security taxes withheld.

Essentially, what the Windfall Elimination Provision does is reduce the amount of your average monthly earnings that are subject to the 90% multiplying factor. The multiplier can be reduced to as little as 40%, and the exact amount of the reduction depends on how many years you had with "substantial earnings" that were taxed by Social Security.

The Social Security Administration provides a chart that defines what qualifies as substantial earnings in any given year. Just to give you an idea of what this means, "substantial earnings" for 2015 is defined as $22,050, and prior years are reduced to reflect the effects of inflation. If you achieved substantial earnings in 30 or more years of your working lifetime, the Windfall Elimination Provision doesn't apply to you. On the other hand, if you had fewer than 30 years of substantial earnings, the 90% multiplier that would normally be used to determine your Social Security benefit will be reduced according to the following chart.

If you had this many years of "substantial earnings"...

...then your 90% multiplier is reduced to...

30 or more

90%

29

85%

28

80%

27

75%

26

70%

25

65%

24

60%

23

55%

22

50%

21

45%

20 or less

40%

There is also a stipulation that protects you in the event your pension income turns out to be low. The Windfall Elimination Provision will not reduce your Social Security benefit by more than half of your pension for post-1956 earnings on which you didn't pay Social Security tax.

If you'd like to check to see whether or not the Windfall Elimination Provision could affect your Social Security benefit, the Social Security Administration provides a calculator designed specifically for this purpose.

The bottom line
If you receive a pension from an employer who did not withhold Social Security tax from your paychecks, the Windfall Elimination Provision is designed to ensure that your Social Security benefits are calculated in a manner that reflects how much you earned during your working lifetime, as well as how much you're receiving in pension income. However, whether or not you're affected depends on how much of your income did have Social Security tax withheld. And the worst outcome of the Windfall Elimination Provision would be a reduction (but not a complete elimination of) your calculated Social Security benefits.

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.