Whether you’re on the cusp of retirement, meticulously planning your future, or simply curious about the financial safety nets available in your golden years, use this guide to a secure and stable retirement.

The Social Security credit system

For individuals born after January 2, 1929, a total of 40 credits is the golden number to qualify for Social Security benefits. In 2023, you can secure one credit by earning $1,640, whether through wages or self-employment income. You have the opportunity to earn up to four credits annually, which means you’d need to generate $6,560 within a year to claim them. The flexibility here is that you can earn this amount at any time during the tax year.

Self-employed individuals might wonder if this system applies to them. The straightforward answer is yes; self-employed people accumulate Social Security credits in the same manner as those who are employed by others. So, managing your own business doesn’t create additional hurdles in accruing these essential credits.

Achieving the 40-credit milestone requires at least 10 years of meeting the minimum earning threshold, but these years don’t need to be back-to-back. It’s crucial to note that once you’ve secured the required 40 credits, amassing more doesn’t enhance your benefit payment. Instead, the amount you receive upon retirement is calculated based on your earnings throughout your working life, providing a financial safety net reflective of your career’s fiscal history.

How is your Social Security calculated?

The amount you will receive upon reaching your full retirement age, which falls between age 65 and 67 depending on your birth year, is called the Primary Insurance Amount (PIA). The PIA is not a random figure, it is meticulously calculated based on a formula that considers your Average Indexed Monthly Earnings (AIME) during your 35 highest-earning years after age 21, up to the Social Security wage base. 

In 2023, the Social Security wage base is set at $160,200, which is an increment of $13,200 from the previous year. This wage base represents the maximum amount of income that is subject to Social Security taxes. Employees are obligated to pay a 6.2% tax up to this income level, and employers contribute an additional 6.2%. For those who are self-employed, they are responsible for paying both portions of this payroll tax, which funds Social Security.

The calculation of AIME involves considering earnings from a worker’s 35 highest-earning years, which are tallied and indexed for inflation. If a person has worked for fewer than 35 years, the missing years are accounted for with zeros in the calculation. Conversely, if they have worked for more than 35 years, only the highest-earning years will be considered.

The AIME is then segmented into three parts, known as bend points, which are adjusted annually for inflation and play a crucial role in determining the worker’s PIA. The bend points for 2023 are as follows: 

  • 90% of the first $1,115 of AIME
  • 32% of earnings between $1,115 and $6,721
  • 15% of earnings above $6,721

Let’s illustrate this with an example: consider a 62-year-old individual born in 1957 with total indexed earnings of $2.5 million over their 35 highest-earning years. This would result in an AIME of $5,952.38 ($2,500,000 / 420 work months). 

The first bend point, $1,115 of the AIME, is multiplied by 90%, equating to $1,003.50. The individual then earned an additional $4,837.38 ($5,952.38 minus $1,115), which is multiplied by 32%, resulting in $1,547.96. 

Since the worker had no earnings above $6,721, there’s no benefit at this level. Adding those figures, they amount to $2,551.46. The benefit amounts are rounded down to the nearest dime, so the PIA for this worker, if they wait until their full retirement age (66 + 6 months) to collect Social Security, is $2,551.40. However, if they choose to retire early, this amount can decrease by up to 30%.

Understanding the bend points and formulas, which are determined annually by the Social Security Administration, enables you to make informed decisions about when to retire and how to optimize your benefits, ensuring a financially secure future.

What are Social Security benefits based on?

Lifetime Earnings

  •   Your Social Security benefits are fundamentally based on your cumulative lifetime earnings.
  •   Earnings are adjusted or “indexed” to accommodate changes in average wages since the year they were received.

Calculation of Average Indexed Monthly Earnings (AIME)

  •   – AIME is calculated by analyzing your earnings during the 35 years in which you earned the most.
  •   – A specific formula is applied to these earnings to derive your basic benefit, termed the “Primary Insurance Amount” (PIA).

Age of Claiming Benefits

  • You have the option to file for benefits as early as age 62.
  • Claiming benefits before reaching full retirement age (usually 65 or 67) will result in a reduced monthly benefit.
  • If you delay claiming benefits until after full retirement age, your monthly benefit will increase, up until age 70.

Delaying Social Security After Full Retirement Age

  • Each year you delay claiming Social Security after reaching full retirement age (and up until age 70) results in an 8% increase in your benefit.
  • This delay essentially provides a permanent increase above the benefit you’d have received at full retirement age.

Government Workers with a Pension

  • For government workers who also receive, or are eligible for, a retirement or disability pension from work without paying Social Security taxes, a different formula may be applied to the AIME.
  • This alternative formula ensures that your Social Security benefits are calculated in a way that reflects both your earning history and pension eligibility.
  • Understanding these key factors allows you to navigate through the complexities of Social Security benefits, enabling you to make informed decisions that optimize your financial stability during retirement.