Most Americans rely on a combination of Social Security and savings to provide income during retirement, but this strategy requires careful planning in advance. That’s due to the impact your Social Security income has on the amount you need to save to retire.
To determine how much you will need to save for retirement, you will need to understand how much of your expected expenses will be covered by Social Security income. Then, you can save to cover the rest. This process starts with calculating how much you will earn from Social Security when you plan to retire.
You Must Qualify for Social Security to Receive Benefits
Before you begin to calculate your Social Security benefits, you first need to know if you qualify. There are several types of benefits including disability, spousal, and survivor, but this article will focus on retirement benefits earned through your own work.
To earn retirement benefits based on your work history, you need to accumulate 40 credits over the course of your lifetime. In 2024, you earn one credit for every $1,730 in income from a covered source – such as wages and self-employment income – up to four credits per year. The required income threshold is adjusted each year for inflation.
Based on these figures, you are eligible for Social Security benefits if you work 10 years in a job that is subject to Social Security tax and earn at least the minimum amount per year. The years you work do not have to be consecutive, nor do you have to work full-time to earn credits.
The Social Security Benefit Calculation Starts with Determining Your AIME
If you meet the qualification criteria for Social Security, you need to understand how to calculate your benefits. The first part of this calculation requires determining your Average Indexed Monthly Earnings [AIME]. This figure is the average of your highest 35 years of earnings, adjusted for inflation. To calculate your AIME, follow these four steps.
1. Determine Earnings History
To calculate AIME, you first need to know your earnings from all years in which you had covered income – meaning income from wages or self-employment that was subject to Social Security taxes. Your employer reports your earnings to the Social Security Administration each year and you can review your earnings record through your Social Security account.
If you worked fewer than 35 years, zeros are used in place of years without earnings.1 Due to this part of the calculation, your benefits can be reduced based on the years you did not work.
2. Adjust Your Earnings for The Benefit Base Cap
If you’re a high earner, you may have noticed that you don’t pay Social Security tax on all your income. That is because individuals only contribute to the Social Security’s Old-Age, Survivors, and Disability Insurance [OASDI] fund on income up to the Contribution and Benefit Base. This threshold is adjusted annually for inflation, and it is $168,600 in 2024.
Income above this threshold is not subject to Social Security tax. Therefore, the income used for your benefit calculation is capped at that amount as well.
When manually calculating your benefits, review your prior year earnings and adjust them to match the cap in each applicable year. You can find a list of the historical caps on the Social Security Administration website.
3. Adjust Earnings for Inflation
Once you have your income for each year and have adjusted it according to the benefit base cap, you need to index it for inflation. The Social Security Administration uses the Average Wage Indexing Series to determine the appropriate inflation adjustment. The indexing factor used to adjust your earnings varies based on the year you become eligible for benefits. You can find indexing information for your situation on the Social Security Administration website.
When reviewing the indexing factors for your specific situation, you may notice that the final two years before you become eligible for Social Security have an indexing factor of 1. That is because wages are indexed to the average wage level 2 years before you become eligible for Social Security. For example, if you turn age 62 in 2024, your earnings would be indexed to the average wage in 2022.
4. Average Highest 35 Years of Earnings
After making a list of all earnings and adjusting for the income cap and inflation, you can determine the 35 years with the highest inflation-adjusted earnings. These are the amounts that will be used to calculate your Social Security benefit.
Add your inflation-adjusted earnings from the highest 35 years, then divide by the total number of months in those years. Round down to the next lowest dollar and you have your AIME.
Calculating Social Security Benefits with Average Earnings
Your AIME is the key to determining your Primary Insurance Amount [PIA]. This is the benefit you would receive if you began receiving Social Security at your Full Retirement Age – 67 for those born in 1960 or later.
PIA is determined using two “bend points.” These are thresholds that determine how much of your AIME is replaced by Social Security.
Your PIA is the sum of:
- 90% of AIME up to Bend Point 1
- 32% of AIME between Bend Point 1 and Bend Point 2
- 15% of AIME over Bend Point 2
The total of these amounts is rounded down to the nearest $0.10.
Bend points are adjusted each year for inflation, and you should use the ones that apply in the year you first become eligible for Social Security. For example, if you turn 62 and become eligible for Social Security in 2024, the bend points are $1,174 and $7,078.
To illustrate the PIA calculation, consider the following example.
Due to the applicable bend points, workers with higher pre-retirement incomes tend to see a lower percentage of their income replaced by Social Security. For example, the average person who earned $50k per year prior to retirement receives about 35% of their pre-retirement income in Social Security benefits. On the other hand, someone who earned $300k per year during their working years will only receive about 11% of their pre-retirement income from Social Security.
Other Factors That Influence Your Social Security Income
As previously mentioned, your PIA is the baseline amount of your Social Security benefit. The actual amount you receive each month can be different depending on several factors.
Adjustments for Early or Delayed Social Security Benefits
You can begin receiving Social Security benefits at any time between the ages of 62 and 70. You receive less than your PIA if you take benefits before your Full Retirement Age and you can receive a higher monthly benefit if you delay benefits up to age 70.
For example, if your full retirement age is 67 and…
- you begin benefits at 62, you receive 70% of PIA.
- you begin benefits at 67, you receive 100% of PIA.
- you delay benefits until age 70, you receive 124% of PIA.
These age-based adjustments make choosing when to begin Social Security benefits one of the most important decisions to your retirement plan. Be sure to consider your options and discuss them with an experienced financial advisor before you begin benefits.
Annual Cost of Living Adjustments for Social Security Benefits
After your benefits are calculated, they are adjusted each year based on inflation – known as the Cost of Living Adjustment [COLA]. These adjustments are announced each year around October and are based on the inflation rate from Q3 of the previous year through Q3 of the current year. The change is reflected in your benefits beginning in January of the following year.
Social Security Benefits Can Be Subject to Tax
Taxes are another factor that can influence your Social Security income. If your provisional income is over certain thresholds, you can owe tax on up to 85% of your benefit amount.
The Earnings Test Can Reduce Your Monthly Social Security Benefits
Prior to your Full Retirement Age, you could be subject to the earnings test. This rule withholds a portion of your benefits if your income exceeds certain levels. Those withheld benefits are paid back to you over the course of your life once you reach Full Retirement Age.
As you can see, the calculation of Social Security benefits can be complex and relies on many different factors. Rather than tackling the ins-and-outs on your own, partner with an experienced financial advisor who can take this work off your plate.
Meld Financial Has Answers to Your Most Pressing Social Security Questions
At Meld Financial, our experienced team can help you forecast your Social Security income and understand your benefits. These benefits are an important part of your larger financial plan – and we can help with that too!
Over four decades of helping clients achieve their retirement goals, we developed a comprehensive wealth management program called Financial Fingerprint®. This nimble plan brings together the most important aspects of your retirement into one easy to understand plan overseen by our team of tax, legal, and investment professionals.
Contact us to learn more about Financial Fingerprint® and get started today.
Sources:
1 Social Security Administration. (2024, January). How you become eligible for benefits. https://www.ssa.gov/myaccount/assets/materials/EN-05-10703.pdf
