Social Security plays an important role in the retirement plans of millions of Americans. If you expect it to play a role in yours, there are a few key rules around how it works that you should understand in order to make sure the way it acts fits with the way you need it to act.
The general rule is that your benefits are based on the taxes you pay to the program throughout your working life. Still, the level of benefits it provides and the way it interacts with pensions, other key retirement plans, and your overall income could trip you up if you're not prepared. By the time you're retired, it may be too late to work around those potential surprises -- so it's a good idea to understand them well enough in advance so that you have adequate time to get ready.
What will you get?
Your base Social Security benefit level is based on a formula called "AIME" -- or Average Indexed Monthly Earnings. The key drivers of that formula depend largely on three factors:
- The number of years you work in jobs covered by Social Security.
- Your salary during those working years.
- The index of your wages vs. the national average during those years.
Social Security replaces around 40% of the typical retiree's pre-retirement income, though your level will differ based on your particular circumstances. Not even Social Security knows exactly what your benefit will be until you file for it, but it can give you its best estimate if you sign up online for a "My Social Security" account.
Social Security also adjusts your payment based on when you start collecting. Your AIME benefit level is based on you starting to collect at your full retirement age, but you can collect less as young as age 62 -- or more if you wait past your full retirement age, with benefits increasing up to age 70.
What could keep you from getting that level of benefits?
If you haven't worked in covered jobs long enough, you won't qualify for benefits. You need at least 40 credits to qualify. You receive a credit for each $1,220 you earn in a year, but you can't earn more than four credits in a year. If you don't put in enough time, you won't receive benefits under your own earnings record, but you may receive spousal benefits if you're married to someone who does qualify.
If you've also worked in certain jobs covered by other retirement programs, your benefits will be reduced. For instance, some state and local government employees are not covered by Social Security. If you've hopped between covered and non-covered jobs, the "Windfall Elimination Provision" will likely reduce your Social Security from what you'd otherwise expect based on your covered earnings.
If Social Security's Trust Funds empty, benefits could be cut by around 23%. The Trust Funds are currently on track to empty by around 2033. While Congress has patched Social Security several times in its past to prevent benefits from being cut this way, there are no guarantees until a patch is passed and the ink is dry on the president's signature.
What else could affect your total retirement benefits?
If you have a pension plan integrated with Social Security, then your pension plan may reduce its payment based on your Social Security benefit level. If you retired before Social Security eligibility but were expecting both your total pension plus Social Security once you reached a qualifying age for Social Security, that could be an unfortunate surprise.
If your total income is high enough, your Social Security benefits will be taxed. For single tax filers, Social Security benefits start getting taxed at $25,000 of "combined income." For those who are married filing jointly, Social Security benefits start getting taxed when that combined income level reaches $32,000. Nearly all who are married and file separate returns will see their Social Security benefits taxed.
As for that "combined income," it's calculated as your Adjusted Gross Income plus non-taxable interest income, plus half of your Social Security benefit. Depending on that combined income level, up to 85% of your Social Security benefit could be taxed.
Social Security still fits into your retirement plan
Despite those factors that could reduce your Social Security benefit or your total retirement income from what you may have originally thought, Social Security can still play an important role in your plan. Just don't expect more from the program than it's on track to give you, and be sure to design your end-to-end retirement plan around those limitations.
By planning around those gaps before they catch you by surprise, you'll put yourself in a much better place than if you're forced to scramble after they've affected you. That gives you your best chance of having the quality of life in retirement you've been looking forward to.