How Is Social Security Calculated, Actually?

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Over 40% of Americans rely solely on Social Security for their retirement, despite that being exactly what you’re not supposed to do! That’s a significant chunk of the population depending on a single source of income. But how is that income actually determined?

It’s a common misconception that Social Security is a flat benefit that everyone receives. The reality is far more complicated, though. The calculation method employs a complicated formula that considers inflation and prioritizes higher earnings. In theory, it’s meant to be fair and equitable across the board.

However, some workers still feel shortchanged and surprised when they receive their first check in the mail. 

Let’s take a look at the nuisances behind the Social Security formula, exploring how it works and impacts your retirement income. It’s important to have reasonable expectations for retirement and Social Security. 

What Is The Social Security Formula?

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Calculating your Social Security benefit rests largely on determining your AIME.

Social Security is not a flat payout. Instead, it hinges on a concept called Average Indexed Monthly Earnings (AIME). This term is mighty complex, but it basically boils down to the average of your 35 highest-earning years adjusted for inflation. Let’s look at how Social Security calculates AIME:

  1. Lowest Years are Excluded: First, your lowest earning years are thrown out. This process acknowledges that most people do not earn a nice, even amount throughout their careers. If you take a break in your career or have a period of low income, this won’t affect your retirement benefits.
  2. Inflation is Factored In: Imagine earning $50,000 in 1980 as one of your highest earning years. Back then, that was a lot! However, these days, that isn’t a huge amount due to inflation. To keep things fair, Social Security adjusts all earnings to inflation. This ensures your benefits reflect the cost of living when you actually need them.
  3. A Percentage is Applied: Social Security replaces a certain amount of your AIME. However, the percentage is dependent on your income. Lower-income earners may get as much as 90% of their pre-retirement salary. However, the more you earn, the lower the percentage you get. 

This process has been around for decades. While many people consider it fair, others do not. It can create several potential issues.

How Does Age Affect the Formula?

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Your age has a massive effect on your Social Security benefits.

The age at which you retire directly impacts your monthly benefits, too. 

If you retire at full retirement age, you can expect to receive the monthly payment you’d expect based on your AIME. Currently, the full retirement age is around 66 to 67, depending on your birth year. 

You can retire early, though. You can start claiming Social Security benefits as early as 62, but this comes at a cost. Your benefit amount is reduced permanently for each month you claim before you reach full retirement age. This reduction can be huge. If you claim right at 62, for instance, you could earn more than 30% less each month. 

Some people choose to delay retirement. If you wait past your FRA, your monthly benefit amount increases slightly. This delayed retirement credit can be an attractive option for those who can afford to wait and want to maximize their monthly Social Security income.

The increase stops at age 70 when you’ll receive your maximum benefit.

The Impact: Benefits and Shortcomings

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There is a lot of political debate surrounding the Social Security formula. Some believe it should provide a larger income for those with a lower AIME.

As we saw, the Social Security formula factors in your highest earning years. It does not just provide a flat earnings amount. This ensures that your benefits are at least partially based on your pre-retirement living standard and the taxes you paid. 

As you likely know, Social Security and taxes are closely tied together. 

Those who earn a higher salary can expect a higher monthly benefit, reflecting their higher cost of living before retirement. 

The Low-Wage Earner’s Gap

The AIME formula focuses heavily on higher earnings. However, if workers receive proportionally low wages throughout their careers, they will get lower benefits. The current average Social Security check is around $1,760. Lower-income earners may receive far less, though. 

For example, imagine two workers, Sarah and Michael. Sarah earns $80,000 annually, while Michael works various part-time jobs, averaging $30,000 annually. While both pay into Social Security, Sarah’s higher earnings will likely translate to a significantly higher monthly benefit than Michael’s.

Furthermore, it isn’t necessarily based on how much you paid. Michael may pay 80% of the amount Sarah does in taxes. However, due to his lower income, he may make 50% less. Social Security taxes are front-loaded, which means that they get paid by those with lower incomes. However, you stop paying Social Security taxes once you make enough income. 

That said, Michael likely has a lower cost of living, so the lower Social Security amount will likely replace a higher proportion of his income.

Based on the current Social Security calculations, Michael would receive around $15,000 annually, replacing 50% of his income. However, Sarah would only receive around $30,000, replacing only 37% of her income. 

So, yes, those with a lower income will receive less monthly. However, in theory, they should receive a higher portion of their pre-retirement income in Social Security benefits. 

How Social Security is Calculated for Survivor and Disability Benefits

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If you’re disabled, your monthly benefits will be calculated in a similar way.

While most associate Social Security with retirement benefits, it’s important to remember that AIME is used to calculate all types of Social Security. The Social Security program also provides survivor and disability benefits, which are calculated similarly. 

  • Survivor Benefits: In the event of a spouse’s death, Social Security can be a lifeline for surviving spouses and children. In much the same way as retirement benefits, survivor benefits are calculated based on the deceased earner’s history. These benefits are only available if the deceased person paid Social Security taxes.
  • Disability Benefits: For individuals with a qualifying disability that prevents them from working, their Social Security benefits are calculated similarly to retirement benefits. However, you may not need 35 years of income, depending on your age. Younger workers need far fewer years. Disability is a bit complicated, so we have a whole article about Disability Benefits for you to look at. 

Understanding how the Social Security formula applies to these benefits is just as important as understanding it for retirement benefits. You can always calculate your potential benefits online through the SSA website. 

Common Misconceptions about How Social Security is Calculated

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Despite many people receiving Social Security benefits, there are still several common misconceptions about how it is calculated.

Social Security is a bit complicated. However, it’s calculation doesn’t have to be completely shrouded in mystery. Let’s take a quick look at some common misconceptions so you can be better prepared for how much you may receive each month:

Myth #1: Social Security is a flat benefit.

As we’ve discussed, Social Security is far from a flat benefit. Instead, it’s based on your Adjusted Indexed Monthly Earnings (AIME). Your highest 35 years of adjusted income are considered, so those with a higher average income typically receive more each month. 

Myth #2: You only have to work until age 65 to receive benefits. 

65 is no longer full retirement age. For many people, to receive full benefits, you must work until you’re 66 or 67. The age that you claim is very important, so you must understand how much you could receive by age. “Full benefits” would be calculated using only the equation we discussed in this article, without any adjusting for your age. 

Simply put, it’s your baseline. 

You can technically start claiming as soon as you hit 62. However, this would permanently reduce your monthly benefit amount. You can also delay retirement, which would increase your benefit slightly each month. 

That said, we don’t recommend waiting until 70, even though this is when you would receive the most money possible. 

Myth #3: Social Security benefits are based solely on your own contributions. 

Despite how it may appear, Social Security is not a savings account. When you pay taxes, that money is not tucked away somewhere and waiting for you. Current worker contributions go towards benefits for retirees today. The system relies on having enough workers to pay the retirees and others receiving benefits. 

How much you pay in taxes does not directly affect your monthly benefits. Instead, your benefits are only based on your highest 35 earning years. 

Myth #4: Social Security benefits are not taxed.

Because Social Security is a government program, many assume it isn’t taxed. However, this isn’t true in the least. Depending on your total income, up to 85% of your Social Security benefits may be subject to taxes. It’s important to understand how Social Security and taxes work!

If you want a deeper explanation, be sure to check our Social Security Guide

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