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.

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 five-step process.

1. Make a year-by-year list of your earnings, excluding any earnings for each year that were in excess of the maximum amount subject to Social Security tax.
2. Adjust your earnings from prior years to today’s dollars.
3. Select your 35 highest-earning years.
4. Add up the total amount of earnings in those 35 years.
5. 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 2022, his or her primary insurance amount would be:

• 90% of any AIME up to $1,024, plus
• 32% of any AIME between $1,024 and $6,172, plus
• 15% of any AIME above $6,172.

Note that these figures change to account for wage inflation each year. So, for example, for somebody turning age 62 in 2023, 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 $12,288 of average annual wage-inflation-adjusted earnings, plus
• 32% of average annual wage-inflation-adjusted earnings from $12,288 to $74,064, plus
• 15% of average annual wage-inflation-adjusted earnings from $74,064 to $137,160.

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 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 1962, so her full retirement age is 67. Her primary insurance amount is $2,000. If she claims retirement benefits at age 65 (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 decides instead to claim at age 62 (60 months prior to FRA), her benefit would be $1,400 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 24 months x $2,000.

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. 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 1960, so his full retirement age is 67. His primary insurance amount is $2,000. If he waits until age 70 (that is, 36 months after FRA) to claim his retirement benefit, he will receive $2,480 per month, calculated as:

• His PIA of $2,000 per month, plus
• ²/₃ of 1% x 36 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:

Adjusting Benefits for Inflation

Every year after you reach age 62, 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 or widow/widower benefit if your spouse should outlive you).

A common misconception is that you must have already filed for your benefit in order to get the cost-of-living adjustment in a given year, but that is not the case. The cost-of-living adjustment is applied to your PIA regardless of whether or not you have filed for benefits.

Simple Summary