April 16, 2010

How Are Social Security Retirement Benefits Figured?

Once a year I get a Social Security Statement (like this) in the mail from the Social Security administration stating the earnings I've paid taxes on thus far and what my estimated benefits would be when I retire.  If you are a worker over 25 you should be getting one too.  My earnings is pretty straight forward and the amount of wages that I paid SS tax on.   How they obtain the estimate the social security retirement benefit is more of a mystery to me.  I know they figure your benefits somehow proportional to your taxed income but I don't know the formula.  I decided I'd find out how they calculate Social Security retirement benefits and it turns out its not too complicated.

The details of the benefit calculations are covered in Your Retirement Benefit: How it is Figured on the Social Security website. You could read that website and it does a pretty good job of explaining how they calculate the benefits.   I'll give my explanation and summary of the process below.

Before you even start to calculate your benefits you have to make sure you even qualify.   To qualify for SS you have to work 10 years at a minimum income level and contribute to SS to qualify for retirement benefits.   They track your qualifying work in quarters of 3 months so you can build up that 10 year total in 3+ month chunks rather than having to work full years.   The minimum income level to qualify for a quarter credit changes every year but currently for 2010 its at $1,120

Once you've qualified with the minimum 10 years of taxed work earnings then here is how they figure your benefits based on your earnings:

Income considered is capped at maximum SS contribution: If you make more than the maximum SS contribution in a given year than its capped at the maximum.   So for example if you did very well last year and made $130,000 then that is well above the $106,800 cap on income for SS.   So they would just use the $106,800 figure.

Older years Inflation adjusted: The income levels are adjusted for inflation using a table of index factors per year.   The older years are multiplied by higher numbers.  If you made $60,000 in 1995 then it would be multiplied by the index factor of 1.67 and count like $100,200 in todays dollars.  Therefore it would count higher than making $60,000 in 2009. 

Use your best 35 years of income: Your 35 highest years of income (after inflation adjustment) are used to figure your SS benefits.   If you contributed to SS for more than 35 years then the additional years are simply ignored.   They only consider your 35 years of highest income levels.   If you contribute for less than 35 years then the years you do contribute are averaged and the fewer years will lower your benefits.   For SS benefit purposes its better to work 35 years for 5% higher wages than work 45 years for 5% lower wages.

Averaged out to Monthly rate: Your average income level from your 35 highest income years is averaged to an average monthly income figure.  The incomes from your 35 highest years is divided by 420 to find the monthly figure. 

Benefits portion of monthly rate:  Your average monthly figure is used to figure your benefit rate.    The benefits are based on a portion of your monthly average. You get 90% of the first $761, 32% of the the amount between $761 and $4,586 and  15% of anything over $4,586.

Short summary of how to calculate benefits
1) Take your actual income per year and cap it at the maximum level.    
2) Adjust for inflation.  
3) Pick your 35 best years and add them up.
4) Divide that total by 420 to get an average monthly figure.    
5) Then you get 90% of the first  $761, 32% of the next $3,825 and 15% of the rest.

So those are the basics of how they figure your social security benefit.   Now keep in mind that this is the amount you get when you retire at the full retirement age (currently 66 years old).   If you retire at age 62 then you get 75% of the maximum benefit.   Your spouse may also be eligible for spousal benefits if they don't qualify for their own SS.

Lets look at some examples of how this all works.

Consider inflation.  

Lets say that you had these income levels for the given years:
1965 : $4,000
1970 : $4,000
1980 : $15,000
1990 : $15,000

The inflation adjustment factors are as follows 1965 : 8.87, 1970 : 6.68, 1980 : 3.3, 1990 : 1.97

So if you adjust your income for inflation you end up with :

1965 : $35,480
1970 : $26,720
1980 : $49,500
1990 : $29,550

While your actual income level in 1965 was only $4,000 and your 1990 income was $15,000 if you adjust these for inflation then your 1965 income is worth more.

Maximum earnings

Lets say you were on a fixed salary contract and made $85,000 every year from 2000 to 2005.   This would put you above the cap on maximum earnings for 2000 to 2002.  So for those 3 years you would only count the income up to the maximum cause thats all you actually paid SS tax on :

Max Actual Used
2000  $     76,200  $     85,000  $ 76,200
2001  $     80,400  $     85,000  $ 80,400
2002  $     84,900  $     85,000  $ 84,900
2003  $     87,000  $     85,000  $ 85,000
2004  $     87,900  $     85,000  $ 85,000
2005  $     90,000  $     85,000  $ 85,000

Implication of using top 35 years

The fact that they only consider the highest 35 years of income can mean a lot of different things to you. 

  • If you work most of your life at put in over 35 years then occasional down years due to unemployment or illness won't significantly impact your SS benefit.
  • You only have to work 35 years to max out your benefits.    But working more years at higher income will increase your benefit rates.
  • Once you've worked 35 years then adding additional years at lower income level won't change your SS benefit at all.  i.e. if you work 35 years and retire early then don't work extra for low wage just to keep SS higher.
  • If you work fewer than 35 years then the non working years will lower your average but as long as you work the 10 years minimum to qualify you'll get benefits.  Generally the more years you work from 10 to 35 then the more benefit you will get, but after 35 you get no further increase to benefits.

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