If you are planning for retirement or are nearing that time of life and thinking about claiming Social Security, you should understand how your retirement benefits work. Specifically, it's helpful to know how your monthly check amount will be calculated since understanding this information can help you make more informed claiming choices.
Here are three things to know about how the formula works to guide you in making the right choices both during your working years and as a near-retiree.
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1. They're based on average wages
The first thing you should know about your Social Security benefits is that the amount you receive as a retiree is directly linked to the amount you earned over your working life. Specifically, benefits equal a percentage of average-indexed monthly earnings (AIME).
Social Security taxes are taken out of each paycheck you earn, with you paying half the tax and your employer paying half. The amount you earn is recorded on your earnings record. When it comes time for you to claim benefits, the Social Security Administration adjusts your earnings over your career to account for wage growth. Your average monthly wage is calculated from these adjusted wages, and you receive a specific percentage of that amount as your standard benefit.
This standard benefit is available to you at full retirement age (FRA). If you claim ahead of that time, early filing penalties reduce your standard benefit by up to 30%, depending on how early you claim. If you claim after that time, late filing credits will increase your benefit by 2/3 of 1% monthly, or 8% annually up until age 70.
Ultimately, your income over your career has the biggest impact on how much retirement income you get, so you should take every opportunity to try to increase it when possible.
2. 35 years of earnings history counts
When the Social Security Administration calculates AIME, they do not necessarily include every year's earnings. The SSA always bases your benefits calculation on the 35 years you made the most money (after the wage growth adjustment occurs).
If you work for fewer than 35 years, there will be some years where the wages that count in your benefit calculation equal $0. If you work for more years, some of your lowest-earning years won't count.
Say you worked exactly 35 years, and during one of those years, you only made the inflation-adjusted equivalent of $10,000 because it was your first job and you worked part-time. If you're now making $60,000, you could work for one additional year, so you'd have a 36-year earning record. Your AIME would then be calculated using the year you made $60,000 instead of the year you made $10,000.
Obviously, the more years you can work at a higher salary, the bigger your AIME will be and the higher your standard benefit will become.
3. You only get credit for wages each year up to the wage base limit
There's one caveat to be aware of about the benefits formula, though. Very high earners won't get credit for all their wages when AIME is calculated.
Each year, there is a wage base limit. You won't pay Social Security taxes on money above the wage base limit, and money above it won't count during your AIME calculation. In 2023, the wage base limit is $160,200. So every dollar you earn up to that amount will be subject to Social Security tax and counted on your earnings record. But no matter how much you make above that amount, it won't increase your Social Security taxes or your future payments.
By understanding these three factors, you can make better, more informed choices about your career path and about how many years you should try to stay on the job if you're making more at the start of your career than you did at an earlier point. Since Social Security is an important income source, being armed with this information can really pay off for you as a retiree.
