We’ve discussed a handful of Social Security topics so far, from taking benefits early and investing them to how Social Security benefits are taxed.
Today let’s take a step back and cover how your Social Security benefits are actually calculated in the first place.
As a point of clarification, this article provides the method for calculating your “primary insurance amount”–the amount of benefits you would receive if you claimed benefits starting at your full retirement age. The actual amount you receive will be higher or lower depending on when you start taking benefits.
Calculating Your Average Indexed Monthly Earnings (AIME)
As you probably know, Social Security 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:
- Adjust your earnings from prior years to today’s dollars.
- Select your 35 highest-earning years.
- Add up the total amount of earnings in those 35 years. (Note: Earnings beyond the annual limit for Social Security tax will not be counted.)
- Divide by 420 (the number of months in 35 years).
The result is your “average indexed monthly earnings” (AIME).
So How Much Is Your Benefit?
For someone becoming eligible (that is, reaching age 62) in 2011, your primary insurance amount would be:
- 90% of any AIME up to $749, plus
- 32% of any AIME between $749 and $4,517, plus
- 15% of any AIME above $4,517.
To convert those AIME figures to annual amounts, Social Security would replace:
- 90% of the first $8,988 of average index-adjusted annual earnings, plus
- 32% of the next $45,216 of average index-adjusted annual earnings, plus
- 15% of the next $40,932 of average index-adjusted annual earnings. (It maxes out at this point due to historical caps in Social Security tax.)
Or in graph form:
In other words, Social Security replaces a higher portion of wages for lower-earning workers than for higher-earning workers.
Retirement Planning Application
If you’re currently nearing retirement and attempting to determine how many years you have left at your job, be sure to consider the impact that working another year (or two or three) would have on your Social Security benefits.
If your AIME (based on your 35 highest-earning years) includes any years with very low (or zero) earnings, working additional years would result in those low-earning 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 calculations.
Update: Oblivious Investor reader Dale shared a graph that I found very helpful. It simultaneously shows a) the effect of working more years and b) that Social Security replaces a higher portion of income for lower-earning workers.
Important note: As always, these are just the general rules. There are exceptions. If you’re looking for a more thorough discussion, I’d encourage you to check out the Social Security Handbook.
