Have you ever wondered how your Social Security benefit is calculated? Although the benefit formula is comprised of three basic steps, there are several adjustments that make the calculation a bit complicated.
First, anyone with 40 quarters (10 years) of earnings is entitled to a Social Security benefit (some exceptions exist for certain government and railroad workers). To earn a quarterly credit, you must make at least $1,640 (as of 2023).
Ten years of credits is the minimum for Social Security eligibility, but the actual calculation of benefits is based on your highest 35 years of inflation adjusted earnings. For this reason, it’s important to review your Social Security statement to ensure the annual earnings on record are accurate.
The Benefit Calculation
It should be noted that Social Security converts everything into months for the purposes of calculating benefits. However, we’re going to talk mostly in years because it’s easier for the average person to understand.
The first step in the benefit calculation process is adjusting your earnings history for inflation and then identifying the highest 35 years. The average of this highest-35 is taken to establish your “average indexed monthly earnings” which is used in the next step.
The second step is applying your high 35-year average to the “basic benefit formula.” The sum of this calculation is technically referred to as your “primary insurance amount.”
The benefit formula is designed to replace a higher percentage of earnings for lower income workers. To achieve this, the formula uses tiers. For 2023, the income replacement tiers are as follows:
In other words, Social Security is designed to replace 90% of your first $13,380 of average annual wages, 32% of the next $67,272 and finally, 15% of up to the next $79,548. Average wages above $160,200 do not count toward the benefit calculation.
For example, if your 35-year inflation adjusted average was $100,000, the calculation would look like this:
Important Point – the tiered benefit formula (in the FIRST table above) adjusts annually for inflation. Further, the formula used to calculate benefits is the one in place the year you turn age-62. So, for someone turning age 67 in 2023, the tiered formula used to calculate their benefit would be the one from 2018 (the year they reached age-62). The benefit formula for every calendar year can be found at ssa.gov.
BUT YOU’RE NOT DONE YET!
The final step involves two adjustments. First, if you start benefits sometime after age-62, the primary insurance amount (PIA), calculated in the previous step, will receive cost of living adjustments. For example, if you start drawing benefits at age 66, your PIA would be credited for 4-years of cost-of-living adjustments as part of the benefit calculation.
Second, your benefit will be reduced for drawing benefits before full retirement age or credited for deferring beyond. The factor adjustment for drawing at different ages can be seen in the table below:
The benefit calculation in simple terms
The multiple-steps and adjustments make the benefit calculation seem complicated. Put simply, the Social Security calculation essentially involves:
- Determining your highest 35-years of inflation adjusted earnings,
- Running the average through the tiered formula, and
- Making final cost of living adjustments and reductions/credits depending on your age when benefits begin.
Remember, Social Security uses 35 years of earnings history to calculate an average. If you don’t have 35 years, you’ll have some zeros as part of your average.
Also, earnings above the first two tiers, which works out to $80,652 ($13,380 + $67,272), only get a 15% weighting in the benefit formula. Therefore, even though FICA taxes go all the way up to $160,200 in 2023, in the context of calculating Social Security benefits, the first $80,652 of earnings count a lot more than the next $79,548. The biggest question for most individuals is when to take Social Security. There are many factors to consider including marital status, working status, health and one’s larger financial situation. Helping people make the optimal decision based on their circumstances is a major focus of our firm. If you need help determining the optimal timing for Social Security, please consider our FREE ASSESSMENT to get started on your retirement plan.
*Social Security only adjusts wages for inflation through age-59. Therefore, if you work until age 67 for example, wages earned from age 60 up to 67 will not be inflation adjusted.