Social Security benefits have always been a crucial part of retirement planning, but now more than ever Americans are relying on their monthly benefit check as their main source of income during their retirement years. According to the National Academy of Social Insurance, Social Security is the sole source of income for roughly 20 percent of Americans aged 65 and older, while more than 80 percent of people in this age group receive Social Security benefit checks each month.
Experts often say that the foundation of a retirement plan is like a three-legged stool, with the legs of the stool being Social Security, employer-sponsored retirement benefits and personal savings.
Considering what a big portion of monthly income Social Security has become for retirees, it’s important to know exactly how your benefit will be calculated.
Determine if you have enough credits
The first step is to determine whether you are entitled to Social Security benefits. In order to qualify for Social Security benefits, you need to accrue 40 credits. If you were born after Jan. 2, 1929, you need 40 credits (or 10 years of work) to receive Social Security benefits.
In 2022, you must earn $1,510 to get one credit. You may earn up to four credits per calendar year. You must earn $6,040 to get the full four credits.
“If you are self-employed, you earn Social Security credits the same way employees do,” says certified financial planner Alexey Bulankov, senior and financial advisor at Merrill Lynch.
The amount you would receive at your full retirement age, which ranges from age 65 to 67, depending on the year you were born, is called the primary insurance amount, or PIA.
The not-so-secret formula to calculating Social Security benefits
The formula for calculating your PIA is based on the average indexed monthly earnings, or AIME, in the 35 highest-earning years after age 21, up to the Social Security wage base. In 2022, the base is $147,000, an increase of $4,200 from last year. The wage base is the maximum amount of income on which Social Security taxes must be paid
“If a person works (fewer) than 35 years, missing years are filled in with zeros. If they have worked more than 35 years, only the highest-earning years will be considered,” says Charles C. Scott, founder and president of Pelleton Capital Management, a financial services firm in Scottsdale, Arizona.
Earnings from a worker’s 35 highest-earning years are tallied at age 62 and indexed for inflation, resulting in the AIME, Bulankov says.
The AIME is “divided into three segments, called bend points (which are adjusted each year for inflation), giving you the worker’s PIA,” says Scott.
Here are the bend points for calculating a worker’s benefits in 2022. The benefit is the sum of the following elements:
- 90 percent of the first $1,024 of averaged indexed monthly earnings
- 32 percent of earnings between $1,024 and $6,172
- 15 percent of earnings above $6,172
For example, a 62-year-old born in 1957 whose total indexed earnings over her 35 highest-earning years were $2.5 million would have an AIME of $5,952.38 ($2,500,000 / 420 work months = $5,952.38).
- The first bend point, $1,024 of the AIME, is multiplied by 90 percent, resulting in $921.60.
- This worker then earned an incremental $4,928.38 (or $5,952.38 minus $1,024). This figure is multiplied by 32 percent, resulting in $1,577.08.
- The worker had no earnings above $6,172, so there’s no benefit at this level.
Add those figures up, and it comes to $2,498.68.
Benefit amounts are rounded down to the next-lowest dime, so this worker’s PIA, which is the amount she would receive if she waits until her full retirement age (66 + 6 months) to collect Social Security, is $2,498.60
Bend points and formulas are set annually by the Social Security Administration.
When to start taking Social Security benefits
Certain factors can change the amount to which you are entitled, such as electing to receive benefits before full retirement age or delaying benefits past the full retirement age. Government workers receiving pension benefits may not be eligible to receive Social Security.
You get a reduced benefit if you claim benefits before full retirement age (as early as age 62), and you get a higher benefit if you delay claiming benefits, up to age 70.
“Claiming Social Security early results in a permanent pay cut from what your benefit would be at full retirement age,” warns Greg McBride, CFA, Bankrate chief financial analyst.
“Better still is that each year you delay Social Security after your full retirement age and up until age 70 results in an 8 percent increase — a permanent pay raise, if you will, above the benefit you’d have received at full retirement age,” McBride says.
Social Security calculations can be complicated, but understanding how your benefit is determined can help you plan for retirement.
You also can estimate your benefits by using the SSA’s Social Security Retirement Estimator.
It’s a good idea to go to the SSA website and create an account so you can get your Social Security statement online. Go to www.socialsecurity.gov/myaccount to review your statement.