Social Security accounts for the lion's share of retirement income for millions of Americans, yet a recent Nationwide survey reveals that 88% of Americans "don't know what factors determine the maximum Social Security benefit an individual can receive."

If you don't understand the complex formula that Social Security uses to determine your benefits, you could wind up getting less than you expect in Social Security income in retirement. Do you know why Social Security's average indexed monthly earnings (AIME) calculation is important? If not, read on to learn how AIME impacts your benefit and tips to maximize your Social Security.

What's your average?

A lot goes into calculating your primary insurance amount, which is the Social Security benefit you can receive when you retire, but it all begins with the AIME calculation.

A woman looking through a magnifying glass.

Image source: Getty Images.

Simply put, AIME is the average amount of taxable-income you earned over your career. However, calculating your average income involves much more than simply summing up your annual income and dividing it by the number of years you worked. There are quirks to this formula that you ought to know about.

First, Social Security only uses your highest 35-years of earned income in its calculation. If you worked over 35 years, your lowest income earning years are ignored. But, if you worked less than 35 years, then Social Security will use zeros in its calculation. For instance, if you only worked 25 years, the AIME formula would include 10 years' worth of zeros. This is important to understand because it means that workers with shorter careers can wind up receiving less in Social Security income than workers with longer careers.

Second, AIME is calculated using your historical income after it's been adjusted for inflation. The most commonly used measure of inflation used by economists is the Department of Labor's Consumer Price Index. However, Social Security doesn't use that inflation gauge. Instead, it uses the average wage index (AWI).

The AWI is determined annually by the Social Security Administration (SSA), with a two-year lag to allow for adjustments. It reflects the national average income subject to federal income taxes plus contributions to deferred compensation plans, such as workplace retirement plans. 

How much your historical income is adjusted by AWI depends on when you turn age 62, which is the earliest age you can claim Social Security benefits. Since there's a two-year lag to AWI, Social Security uses the AWI for the year you turn age 60 when doing this part of your AIME calculation.

For example, if you turn age 62 in 2018, then your earnings would be indexed to 2016's AWI of $48,642.15 (in case you're curious, that's 1.13% higher than 2015's AWI).

To index a year of your past income using the AWI from 2016, you divide $48,642.15 by the AWI for the year being adjusted to get an indexing factor.

For example, let's say you want to calculate your indexed earnings for 2008, when you earned $42,305. First, you would divide $48,642.15 by the 2008 AWI (which happens to be $41,334.97) to get an indexing factor of 1.1768. Then, you'd multiply 1.1768 by your $42,305 in income to arrive at your indexed earnings of $49,784.

Social Security does this calculation for each year you have taxable earnings and then, it sorts the results from low to high to separate out your highest-35 years of income. The following table illustrates how this data would look for a hypothetical age 62 worker who's worked the past 10 years.

Examples of Earnings Before and After Indexing
Year Earnings Index Factor Indexed Earnings
2008 $42,305 1.1768 $49,784
2009 $41,787 1.1948 $49,927
2010 $42,897 1.1672 $50,070
2011 $44,368 1.1317 $50,213
2012 $45,884 1.0975 $50,357
2013 $46,603 1.0836 $50,500
2014 $48,394 1.0465 $50,644
2015 $50,220 1.0113 $50,787
2016 $50,931 1 $50,931
2017 $53,880 1 $53,880

Data source: Social Security Administration.

Once Social Security separates out your highest-35 indexed-earning years (including any zeros for years without any taxable income), it sums the 35 years of earnings and then divides the total by 420, which is the number of months in 35 years.

Voila: This is your AIME.

More to the story...

The AIME isn't the amount you'll get in Social Security in retirement, though. To figure that amount out, Social Security uses bend points to calculate your primary insurance amount, which is the amount you can get if you claim benefits at your full retirement age.

I explained bend points more thoroughly in "Social Security's Bend Points: What Are They?", but to summarize, bend points reduce your AIME by fixed percentages at three different income "points," and those "points" change every year based on changes to AWI.

In 2018, the first bend point is at $895, and the second is at $5,397. This means you get credit for 90% of your AIME up to $895, 32% of your AIME between $895 and $5,397, and 15% of your AIME for anything above $5,397.

A senior woman uses a hoola hoop near a pool.

Image source: Getty Images.

Tips for maximizing Social Security

To increase your Social Security benefit, you'll want to minimize the number of zeros in your AIME calculation or replace low-earnings years used in your AIME calculation with higher-income earning years.

If your work history is shorter than 35 years, every additional year of work will replace a zero in the AIME formula, and if you've worked over 35 years (and your current income is higher than your inflation-adjusted income in the past), then you'll replace one low-income earning year for every high-income earning year you work.

Social Security updates your work record as long as you have taxable earnings, so as long as your income replaces zeros or low-income years, continuing to work can increase your AIME even if you claim Social Security early and work only part time. 

However, until you reach full retirement age, Social Security will withhold $1 for every $2 or $3 earned (depending on your age) if you claim early and your income from work exceeds annual limits. Also, working while collecting Social Security may make some of your Social Security subject to federal taxes, so you'll want to consider that trade-off too.

Alternatively, simply deciding to retire and claim benefits later could be the best way to maximize your benefit. If you wait to claim Social Security, you'll not only replace zeros and low-income years in your AIME calculation, but you'll also receive an 8% increase to your monthly benefit for every year you hold off, up to age 70. For most American's, that's the strategy that will result in the biggest Social Security check.