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How Social Security Benefits Are Calculated

The following is an excerpt from my book Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less.

The size of your monthly retirement benefit depends on:

  1. Your earnings history, and
  2. How old you are when you first begin taking benefits.

But first we need to back up a step. In order to understand how Social Security benefits are calculated, you need to be familiar with two terms:

  • “full retirement age” (FRA), and
  • “primary insurance amount” (PIA).

Your full retirement age depends on the year in which you were born (see table below). Your primary insurance amount is the amount of retirement benefits you would receive per month if you started taking them at your full retirement age. As we’ll discuss shortly, your PIA is determined by your earnings history.

Year of Birth Full Retirement Age
1937 or earlier 65
1938 65 and 2 months
1939 65 and 4 months
1940 65 and 6 months
1941 65 and 8 months
1942 65 and 10 months
1943-1954 66
1955 66 and 2 months
1956 66 and 4 months
1957 66 and 6 months
1958 66 and 8 months
1959 66 and 10 months
1960 or later 67

How Earnings History Affects Retirement Benefits

Your primary insurance amount is based on your historical earnings. Specifically, it’s based on your “average indexed monthly earnings” (AIME). Calculating your AIME is a four-step process.

  1. Adjust your earnings from prior years to today’s dollars.
  2. Select your 35 highest-earning years.
  3. Add up the total amount of earnings in those 35 years, excluding any earnings for each year that were in excess of the maximum amount subject to Social Security tax.
  4. Divide by 420 (the number of months in 35 years).

You do not actually have to do this calculation yourself. The Social Security Administration does it for you. It is, however, important to understand the concept, so that you can understand how your benefit is calculated.

Calculating Your Primary Insurance Amount

For someone becoming eligible for retirement benefits (that is, reaching age 62) in 2012, his or her primary insurance amount would be:

  • 90% of any AIME up to $767, plus
  • 32% of any AIME between $767 and $4,624, plus
  • 15% of any AIME above $4,624.

Note that these figures change to account for wage inflation each year. So, for example, for somebody turning age 62 in 2013, each of these dollar amounts will probably be slightly higher.

Or, to put it in terms of annual income, if claimed at full retirement age, Social Security would replace:

  • 90% of the first $9,204 of average annual wage-inflation-adjusted earnings, plus
  • 32% of average annual wage-inflation-adjusted earnings from $9,205 to $55,488, plus
  • 15% of average annual wage-inflation-adjusted earnings from $55,489 to $98,388.

Two noteworthy takeaways here are that:

  1. Social Security replaces a higher portion of wages for lower-earning workers than for higher-earning workers, and
  2. There’s a maximum possible Social Security retirement benefit. (Few people reach that maximum though, because doing so would require that you earn the maximum earnings subject to Social Security tax for 35 different years.)

If You Worked Fewer than 35 Years

If you have fewer than 35 years in which you earned income subject to Social Security taxes, the calculation of your average indexed monthly earnings will include zeros. For example, if you worked for 31 years, your AIME calculation would include those 31 years of earnings, as well as 4 years of zeros.

As a result, working additional years would result in those zero-earnings years being knocked out of the calculation and replaced with your current earnings. The result isn’t going to make you rich, but it’s worth including in your list of considerations when deciding when to retire.

How Age Affects Retirement Benefits

If you wait until after full retirement age to claim your retirement benefit, the amount you receive will be greater than your primary insurance amount. For anybody born in 1943 or later, the increase is 2/3 of 1% for each month you wait beyond full retirement age (up to age 70, beyond which there is no increase for waiting). This works out to an increase of 8% per year.

EXAMPLE: Alan was born in 1954, so his full retirement age is 66. His primary insurance amount is $2,000. If he waits until age 70 (that is, 48 months after FRA) to claim his retirement benefit, he will receive $2,640 per month, calculated as:

  • His PIA of $2,000 per month, plus
  • 2/3 of 1% x 48 months x $2,000.

If you claim your retirement benefit prior to full retirement age, it will be reduced from your primary insurance amount by 5/9 of 1% for each month (up to 36 months) prior to full retirement age. This works out to a reduction of 6.67% per year. For each month in excess of 36 months, the reduction is 5/12 of 1% (or 5% per year).

EXAMPLE: Allison was born in 1950, so her full retirement age is 66. Her primary insurance amount is $2,000. If she claims retirement benefits at age 64 (24 months prior to FRA), her monthly benefit would be $1,733.33, calculated as:

  • Her PIA of $2,000 per month, minus
  • 5/9 of 1% x 24 months x $2,000.

If Allison instead decided to claim as early as possible, at age 62 (48 months prior to FRA), her benefit would be $1,500 per month, calculated as:

  • Her PIA of $2,000 per month, minus
  • 5/9 of 1% x 36 months x $2,000, minus
  • 5/12 of 1% x 12 months x $2,000.

In short, the interaction between the size of your retirement benefits and the age at which you first claim that benefit looks like this:

Age when you claim retirement benefits Amount of retirement benefit
5 years before FRA 70% of PIA
4 years before FRA 75% of PIA
3 years before FRA 80% of PIA
2 years before FRA 86.67% of PIA
1 year before FRA 93.33% of PIA
at FRA 100% of PIA
1 year after FRA 108% of PIA
2 years after FRA 116% of PIA
3 years after FRA 124% of PIA
4 years after FRA 132% of PIA

Adjusting Benefits for Inflation

Every year after you become eligible for benefits, your primary insurance amount is adjusted to keep up with inflation as measured by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). When your PIA is adjusted upward for inflation, it increases not only your retirement benefit, but also any other benefits that are based on your PIA (e.g., your spouse’s spousal benefits).

Simple Summary

  • Your “primary insurance amount” (PIA) is the monthly retirement benefit you would receive if you claimed benefits at “full retirement age” (FRA).
  • Your primary insurance amount is calculated based on your 35 highest-earning years (after adjusting prior years’ earnings for wage inflation).
  • If you claim retirement benefits prior to your full retirement age, you will receive an amount smaller than your PIA. If you wait until after your full retirement age to claim benefits, your retirement benefit will be greater than your PIA.
  • Social Security benefits are adjusted on an annual basis to keep up with inflation (as measured by the CPI-W).

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."
If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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