The purpose of social security is to replace a portion of the income you earned over your life once you are retired. How exactly your social security benefit amount is calculated is dependent upon several factors.
Earnings
The Social Security Administration looks at your highest 35 years of average monthly inflation-adjusted earnings. In other words, it adds up the highest 480 months of earnings, adjusts all of those earnings to today’s dollars, and divides by 480 months. This number is called AIME or Average Indexed Monthly Earnings and is one component of the social security calculation.
Replacement Rate
The Social Security Administration has come up with a formula for a replacement rate. Based on today’s thresholds, the first $885 of AIME is replaced at 90% ($796.50), the next $4,651 of AIME is replaced at 32% ($1,488.32), the next $5,064 of AIME is replaced at 15% ($759.60) and AIME over $10,600 is not replaced. This suggests that the maximum monthly social security benefit one could collect at Full Retirement Age would be $3,044.42 (not giving effect to inflation adjustments).
Your Social Security Statement
If you are still working, to project what your social security benefit amount will be, the social security administration looks at your prior two years of earnings, averages them out, and assumes that you will earn at that level (adjusting for inflation) until you reach Full Retirement Age.
So, if you are young and at the beginning of your career, it is quite plausible that your benefit amount will actually be much greater than what your statement shows as you could very likely earn more than you have been in the past.
If you are thinking of retiring early, your projected social security benefit on your statement may be higher than what you actually end up receiving at Full Retirement Age. This will depend upon what your earnings looked like over your lifetime.
Consider this example:
John is 60 years old and has been making at least $150,000 since he was 25. If he chooses to retire at 60 or to quit his current job and take a lower paying one, his benefit amount on his statement will be fairly accurate as he has 35 years of history earning at his current level. His AIME would be $10,937.50 ($150,000 x 35 years / 480 months).
Mary is 60 years old and is currently making $150,000. She has been earning at this level for the last 10 years. Prior to that, she was making $75,000 per year. The benefit amount per Mary’s statement will assume that her top 35 years of earnings included 16 years (the 10 years she has been making this amount plus six more years until she reaches FRA) at $150,000 and 19 years at $75,000. This would suggest an AIME of $7,968.75. If Mary actually retires this year, her actual top 35 years of earnings would be 10 years at $150,000 and 25 years at $75,000 for an AIME of $7,031.25. Of course, none of these calculations adjust for inflation which would also have an impact.
Alternatively, if Mary chose to quit her current job and take another if her income at the new job is greater than $150,000 per year her actual benefit amount at Full Retirement Age will be greater than what it says on her current social security statement. If the income at her new job will be less than $150,000 her actual benefit amount at Full Retirement Age will be less than what it says on her current social security statement.
If someone hasn’t worked for a total of 35 years, while he or she will still be eligible for benefits (you need 10 years of work to qualify for benefits), $0 will be used for purposes of calculating AIME for the number of years less than 35 that were worked.
Timing of Benefits
While the information above explains how your benefit amount is calculated at Full Retirement Age, the actual benefit amount that you receive will also be dependent upon how old you are when you begin to collect your benefits. If you collect prior to Full Retirement Age, your benefit amount may be reduced up to an additional 25% if you collect as early as age 62. If you wait to collect until after Full Retirement Age, your benefit amount may be as much as 32% higher, again depending on when you collect (8% per year up to age 70).
In summary, regardless of your current age, as you plan for your retirement, it is critical to understand how social security will play into your overall plans. By understanding how the Social Security Administration estimates your benefit amount and how your actual benefits will ultimately be calculated, you will be able to have a more accurate estimate of what you stand to collect. This will enable you to make more informed decisions regarding employment opportunities and a retirement timeline.