How Social Security Retirement Benefits Are Determined

Kevin Wenke

Kevin Wenke

Owner at Decision Tree Financial. CFP. CLU

People are mystified on how social security benefits are calculated and determined.

If you are like them, you may have questions like “Why do lower income people seem to get proportionately more than higher income earners?” and “how do the years I work impact my benefits?” 

This short article should clear up some of the confusion and also give you some insight into the future of Social Security Retirement

To start, in order to qualify for Social Security benefits, you, or someone who you qualify to share benefits with, such as a spouse, must have earned 40 credits.

In 2020, a credit is earned with $1,410 dollars of earnings.  This amount changes each year with inflation, and you can earn a maximum of 4 credits a year for $5,610 of income.

So, in a sense one needs to work 10 years to be fully insured.  Also, there is no such thing as being partially insured; this is an all or nothing scenario. You are either fully insured or not insured.

Once you have your 40 credits, your benefit amount is determined by taking your inflation adjusted top 35 years of earnings.  This number is based on the value of a dollar when the worker reaches age 62.

This is important because someone can actually increase their Social Security benefit from work they do in their 60’s 70’s or even older but the amount is based on age 62 dollars.  

More on that in a bit, for now know it is the top 35 years of inflation adjusted earnings.

This chart in Illustration 1 is an example of someone’s inflation adjusted 45-year work history. From age 22-66. Remember, the years that benefits are determined by are the top 35 years.

What happens is that Social Security identifies the top 35 year which are still in blue on illustration 2.

Eliminating the lower years has the effect of raising the average.  Since there is a maximum n how much is contributed to the system there is also a maximum on the amount of retirement income that can be received.  That maximum is $11,475 a month for someone turning 62 in 2020.

If a worker didn’t work a full 35 years, zero earnings would be used for the number of years need to do this calculation lowering the average, and the benefits. 

So, with a high income over ten years someone would not be able to work 10 years, retire, and have the maximum $11,475 of monthly earnings. 

Instead, they would have 10 great years and 25 years of zeros dragging it down.

With this 35 years of earning history, Social Security calculates the Average Indexed Monthly Earnings (AIME).  The AIME is used to determine what is known as the Primary Insurance Amount (PIA). Something referred to as bend points help to determine the PIA.

The bend points dictate the percentage of income that is to be replaced by Social Security. See Illustration 3.

For Average Indexed Month Earnings (AIME) that EVERYONE has under $960, Social Security will replace 90% of that income. 

For AIME between $961 and $5,785, 32% of that income is added to the previous bend point, and any AIME above $5,785 will have 15% as income replacement. 

This explains why higher income earners receive less of a percentage than lower income earners.

From the graph (Illustration 4), you can see these 2 bends.  These are the point where income replacement goes from 90% to 32% (which you can see is right about $960/month), the next bend is the point where income replacement goes from 32% to 15

If we add another line to show the percentage of income with values on the right side (Illustration 5), you can see that a low income earner has 90% of their income replaced while someone who had maximum earnings their entire life is only getting a 32% income replacement through Social Security in the future which I have linked my presentation to below

Right now, Understanding how Social Security determines a person’s retirement can help you plan around other parts of your retirement income strategy so you can position yourself to take the least amount of risk to receive the maximum overall benefit

We have self employed couples who shift income from one spouse to another in order to maximize each others potential benefit.

We have individuals decide to work an extra year or two because they not only get the additional income from their work, but they increase their yearly Social Security checks by hundreds of dollars through both delay credits AND a year of work that increases their average earnings

f you have other questions about Social Security, continue reading our other articles of Social Security by clicking here.

If you really want to understand how Social Security works with the rest of your personal finances contact us to learn about our Wealth Performance and Protection System where we can work together to create the financial future you want.

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