How Are Social Security Benefits Calculated?
Calculating Social Security Benefits
Social Security has grown from its humble origin in the Great Depression to become a key source of income for millions of retirees today.
But how are these benefits calculated on a per-person basis?
There are several factors that come into play when it comes to calculating Social Security benefits.
Here is a breakdown of those factors and how they are used to determine the monthly benefit of a given retiree.
Factors That Determine Social Security Benefits
There are four key factors that determine the monthly benefit amount for a retiree.
- The amount of the worker’s earnings over their lifetime
- The length of the worker’s employment in the workforce
- The age at which the worker begins to collect benefits
These four factors are the variables that go into the Social Security benefit calculation.
But to even be eligible to receive benefits, the worker must have been gainfully employed for at least 40 three-month quarters of time.
And in each quarter, the employee must have earned at least a certain amount (that is indexed for inflation each year) in order for that quarter to count towards receiving benefits.
And in all 40 of those quarters, the worker must have paid either the 6.2% Social Security tax if he or she was a W-2 employee or 12.4% if he or she was self-employed.
The purpose of the calculation is to adjust your career earnings to reflect the changes in general wage levels that took place during the years of your career.
The job that paid a worker a $300 monthly income 40 years ago, would yield quite a bit more today.
Social Security says that the adjustments “ensure that a worker’s future benefits reflect the general rise in the standard of living that occurred during his or her working lifetime.”
How to Calculate Social Security Benefits
Calculating Social Security benefits is a three-step process, broken down as follows:
- The worker’s earnings history is used to calculate his or her Average Indexed Monthly Earnings. This is done by using the worker’s annual earnings history for the highest 35 years of earnings. That means that if the worker worked for 40 years, Social Security would use the worker’s highest-paid 35 years in its calculations and ignore the other five. The worker’s highest 35 years of earnings are used to calculate a monthly average. This amount is called the Average Indexed Monthly Earnings (AIME).
- The AIME is then used to calculate a monthly benefit amount known as the Primary Insurance Amount (PIA). The formula that is used to do this uses something called “bend points.” With this formula, the first amount of the worker’s earnings are multiplied by 90%, the next amount is multiplied by 32% and any amount above this is multiplied by 15%. The amounts themselves are indexed annually for inflation.
- The worker can adjust the resulting amount depending upon when he or she wants to begin collecting benefits. If the worker wants to begin collecting benefits at age 62, then the PIA will be reduced by 30%. If the worker wants to begin collecting benefits at age 70, the PIA is increased by 32%.
How Are Social Security Benefits Calculated FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.