Social Security is a major source of income for most seniors. Unfortunately, 88% of older adults don't understand how their maximum potential Social Security benefit is determined, according to a survey by Nationwide. If you don't understand how Social Security benefits are awarded -- or what you can do to boost your benefits -- you may end up getting far less money than you're eligible for.
To make informed choices about Social Security benefits, it's important to know the three big factors that determine the amount of Social Security income you'll receive during your senior years. Here are those three key factors.
1. Average indexed wages
Social Security uses a specific formula to determine how much your monthly check is. The key to this formula is the calculation of your Average Indexed Monthly Earnings, or AIME.
To calculate AIME, the Social Security Administration looks back over your career and adjusts your past earnings to account for inflation by using the Average Wage Index (AWI) to assess how much inflation occurred.
You won't necessarily get credit for every dollar you earned because Social Security caps the amount of income you're taxed on. For 2019, for example, Social Security taxes are only collected on income up to $132,900. If you made $2 million in 2019, you won't have a $2 million income factored in when determining your average wages over your career. Instead, for 2019, the wage that's adjusted for inflation and included when calculating your average would be $132,900.
Your benefits are largely determined by your wages, so earning more now can increase the amount of Social Security benefits you receive as a senior. If you want to earn the highest possible Social Security benefits, look for opportunities to increase your income whenever you can. Negotiating your salary, asking for raises regularly, improving your skills, pursuing promotions, and taking on side gigs are ways to increase your income today and boost your eventual Social Security benefits.
2. Your most profitable 35 years
Social Security doesn't actually consider your wages for every single working year. In determining your AIME, the SSA only counts the 35 years you had the highest inflation-adjusted earnings. So, if you worked for 42 years, the seven years when you had the lowest income aren't counted at all.
Unfortunately, if you did not work for a full 35 years, Social Security doesn't figure out average wages over the number of years you held a job. Instead, it factors in $0 in earnings for the years you didn't work, when calculating your AIME. For example, if you worked for 25 years, you'd have 10 years of $0 earnings counted in your AIME, significantly reducing the average wages you get credit for.
To make sure you don't end up with a number of years of $0 wages factored into your AIME calculation, try to work for at least 35 years. If you're earning a lot near the end of your career, you may also want to work a few years longer so these new higher wages are factored into AIME, which forces those early years of low wages to fall off so they aren't counted in your AIME at all.
3. Your age when you start claiming benefits
After your AIME is calculated, Social Security applies a special formula to it in order to determine how much your monthly benefits will be. Your benefits equal 90% of your AIME up to a certain income level, called a "bend point." Then, you get 32% of AIME up to the next "bend point," and 15% for all additional income. Bend points change each year based on changes to the Average Wage Index.
This formula determines what your primary insurance amount is. But, you only collect your primary insurance amount if you claim benefits at full retirement age. If you claim benefits before your FRA, your benefits are reduced. If you claim after your FRA, your benefits are increased because you earn delayed retirement credits up until age 70.
If you decide to retire at a different age than FRA, you need to understand the impact this can have on your Social Security income. Claiming early reduces benefits by 5/9 of 1% per month for the first 36 months you retire before your FRA. If you retire more than 36 months early, you lose an additional 5/12 of 1% for each prior month. If you retire at 62 when FRA is 67, benefits will be reduced by 30%.
But, if you retire late, benefits increase by 2/3 of 1% per month up until age 70, when the bonus for delaying maxes out. This chart shows you how retiring at different ages could impact total monthly Social Security income.
Retiring early can significantly reduce your monthly benefit, but retiring late means you forgo years of benefits and have to hope you live long enough for higher monthly benefits to make up for all the Social Security income you missed out on by waiting to claim. You can do simple math to figure out how long you'd need to live to break even for delaying the start of your Social Security benefits.
Maximize your Social Security benefits
Now you know the big factors that impact Social Security benefits: your wages over the highest 35-years of your career and the age at which you retire. Knowing this can help you maximize your benefits, as you may decide to work a little longer and delay claiming Social Security if you want your benefit to be as big as possible.