Social Security is the largest retirement program in the United States, but far too many people don't understand how their retirement benefit is determined. Knowing how Social Security benefits are calculated can help you make smart decisions when it comes to claiming your own benefit, and can help you estimate your eventual retirement income for planning purposes.  

With that in mind, here's a quick guide to how the Social Security Administration, or SSA, determines the size of your monthly retirement benefit checks.  

Social Security card inserted in money.

Image source: Getty Images.

Your average indexed monthly earnings 

The first step in the Social Security formula is determining your average indexed monthly earnings, or AIME.  

To calculate your AIME, the SSA takes each year of earnings throughout your working lifetime, up to the Social Security taxable maximum. Then, each year's earnings are adjusted for inflation, or "indexed." 

The formula uses your 35 highest years of earnings to determine your AIME. The calculation is done by adding all 35 years of indexed earnings together, dividing by 35 to find your annual average, and dividing this result by 12 to determine your lifetime monthly average.  

Calculating your PIA 

Your average indexed monthly earnings are then used to determine your basic Social Security retirement benefit, which is officially referred to as your primary insurance amount, or PIA. This is the number that, along with your age at the time you apply, determines your initial Social Security benefit. 

To determine your PIA, your average indexed monthly earnings are applied to a formula. For 2018, the formula is: 

  • 90% of the first $895 in AIME 
  • 32% of the amount of AIME greater than $895, up to $5,397 
  • 15% of the amount of AIME greater than $5,397 

Here's an important point: These percentages stay the same each year, but the thresholds (known as "bend points" change). And your primary insurance amount will be based on the bend points in the year you first became eligible for Social Security. Under current law, this means the year in which you turn 62.

In other words, if you turned 62 in 2015, you would use the bend points of $826 and $4,980 in the formula, instead of the 2018 bend points of $895 and $5,397. (Note: You can find the Social Security bend points for any year on the SSA's website.) 

Here's an example of how this works: Let's say that I'm turning 62 in June 2018 and that my average indexed monthly earnings are $4,500. My PIA will be: 

  • 90% of the first $895, or $805.50 
  • 32% of the remaining $4,105, or $1,313.60 

Combining these two amounts gives me a PIA of $2,119.10 per month. Note that this isn't the actual amount I'd get if I claim at age 62, as we'll see in the "early or late Social Security" section. 

Adding COLAs 

As we just saw, your primary insurance amount is determined by the Social Security bend points in the year you turn 62. If you claim Social Security after the year you turn 62, your PIA will be adjusted upward by any cost-of-living adjustments, or COLA, that have been given.  

Continuing my previous example of a PIA of $2,119.10 in 2018, let's say that I don't plan on claiming Social Security until I reach my full retirement age of 66 years and four months, which will happen in 2022.  

If the COLA for 2019 through 2022 are 2%, 3%, 2.5%, and 0.8%, for example, these would be applied to my PIA to increase my monthly retirement benefit to $2,300.24. So, in this hypothetical example, this is how much I would actually get if I wait until full retirement age to claim my benefit. 

Early or late Social Security 

The other major consideration is if I'm claiming Social Security retirement benefits earlier or later than my full retirement age. Depending on the year you were born, your Social Security full retirement age can be 66, 67, or somewhere in between. 

If you decide to claim Social Security before reaching your full retirement age, the benefit amount calculated by the previous steps will be reduced at a rate of 0.56% per month (6.67% per year) for as many as 36 months before reaching full retirement age, and at a rate of 0.42% per month (5% per year) beyond 36 months early, until as early as age 62. 

On the other hand, if you wait until after full retirement age, your retirement benefit will be permanently increased at the rate of 0.67% per month (8% per year), and this delayed retirement credit can continue to accumulate until you reach age 70.  

A recap 

So, in short, the process used to determine your actual Social Security retirement benefit is as follows: 

  • Your average indexed monthly earnings, or AIME, are calculated as the average of your 35 highest-earning inflation-indexed years, divided by 12. 
  • Your AIME is applied to the Social Security benefit formula, using the bend points that were in effect for the year in which you turned 62.  
  • Any applicable cost-of-living adjustments are applied to your PIA, based on the year in which you actually claim your retirement benefit. 
  • Finally, if you choose to start your benefits at any age other than your exact full retirement age, your monthly benefit will be adjusted up or down.