How Social Security Benefits Are Calculated, and the Cost of Early Retirement

Source: 401kcalculator.org via flickr

Unlike many retirement programs, such as pensions, Social Security is not calculated by applying a formula to your last few years' earnings. What many people don't understand is that Social Security takes decades of earnings into account, and applies different multipliers for different income levels. Here's how your Social Security benefit is determined, and how you determine what early retirement could really cost.

The basic formula, and calculating your benefit
Simply put, your Social Security benefit is calculated with your highest 35 years of earnings, adjusted for inflation, and up to a certain maximum. Using index factors that correspond to each year, the Social Security Administration figures out the average monthly income of your 35 best years.

Then, several multipliers are applied to your average monthly earnings in order to determine your benefit amount. Currently, the benefit is calculated from your monthly earnings as follows:

Note: Social Security takes into account a maximum of $117,000 in earnings for 2014, or $9,750 monthly.

For example, let's say that your calculated average monthly earnings are $2,500. You would take the first $826 of that amount and multiply it by 0.90, which would give you $743.40. Then, the remaining $1,674 is multiplied by 0.32, which gives $535.68. Adding these two amounts together gives a total monthly benefit of $1,279.08.

What about early or late retirement?
Now, the benefit calculated above assumes retirement at full retirement age, which is 66 for people born from 1943-1954, and will gradually rise to 67 for people born in 1960 or later.

If you choose to retire early, your benefit will be reduced depending on how soon you do so. Benefits are reduced by 6.7% per year (five-ninths of 1% per month) for up to three years before your normal retirement age, and 5% per year beyond that, with 62 being the earliest age you can start collecting, regardless of when you were born. So, if your normal retirement age is 67, here is how early retirement could affect the size of your benefits. 

On the other hand, delaying your retirement past your full retirement age will increase your benefit by 8% for every year you wait, up until age 70. So, if your full retirement age is 67 and you choose to wait until 70, your benefit will be 24% greater than it would be if you had retired on time.

How to use this formula to assess your retirement plans
Basically, since the formula takes into account your top 35 years and gives you credit for working longer, there is a double benefit to staying at work for a year or two longer than you had planned, especially if the later years of your career are your highest-earning years.

For instance, many people have a 35-year work history, but the early years of their career might have been in low-paying jobs. So, working an extra year effectively cancels out the lowest year of your 35-year track record and replaces it with a higher number.

Let's say, for instance, that a 62-year-old has worked for 35 years and is considering early retirement. He started his career with a salary of $30,000 per year (in today's dollars), and got an average raise of 3% per year, making his salary about $84,500 today. Based on the formula discussed above and the reduction for retiring early, he could expect a Social Security benefit of $1,404 per month if he decided to retire now.

However, by choosing to work for an extra year or two, his benefit could increase significantly thanks to a higher 35-year average, as well as the higher benefit for working until a higher age. Consider the difference each additional year could make.

Note: Assumes 3% annual raises

Crunch the numbers before you decide to retire early
Now, I realize that Social Security is just one piece of the puzzle when it comes to retiring early and that everyone's situation is different, but the benefit amounts shown in the chart above could have a significant impact in terms of quality of life in retirement. By working an extra year or two, this individual would have that much more time to save for retirement in other ways, such as 401(k) contributions.

Thus, at the end of the day, it pays to know how Social Security benefits are determined and how the decision to retire early might affect yours. If you crunch the numbers and it still seems like a good idea, then go for it, but it's smart to figure out how much potential income you'll be leaving on the table.