Understanding how Social Security is calculated is important so you can see the possible impacts that retiring early may have on your final benefit. You may be years away from considering Social Security. But believe me this is an important part of your long-term strategic retire early plan. When you receive your Social Security Benefit estimate it is important to understand how it is calculated. That way you will be informed and comfortable with your long-term strategic retire early plan.
There are a number of factors used in the Social Security calculation. Such as your years of employment (earning history), mortality tables, wage inflation, a kind of insurance formula and other inflation adjustments.
When you look at your estimate it provides a reduced benefit amount paid out at age 62. Age 62 is the earliest you can file. Your full benefit amount is paid if you wait until your full retirement age 66 – 67. There will also be a higher estimate for age 70.
Your calculated benefit is based on your full retirement and a discounted percentage from there for filing early. Delaying the start of your benefit until age 70 you are given a kind of percentage bonus for filing later.
The Social Security Calculation Pieces
Primary Insurance Amount (PIA).
PIA is a weighted formula giving higher benefits relative to overall career earnings for lower earners than for high earners. First off you (and your employer) must have paid into Social Security for enough time to become covered and considered qualified to be insured. For an age 62 benefit you need to have worked and paid in a minimum of 40 quarters of coverage. In other words to be considered qualified and covered. You need at least 10 years of accumulated work time with a significant amount of earnings. The PIA formula is straightforward using your calculated average indexed monthly earnings (AIME).
Average Indexed Monthly Earnings (AIME).
AIME is an inflation adjustment which uses wages instead of consumer prices. This more or less reflects the U.S. economy’s average wage. This is a calculation where you are normalizing your years of earnings before reaching age 60. It is done by indexing them. Then putting them in a comparative basis within the earnings level of the US as of the year you turn 60. This is all done using the average wage indexing series. It is computed every year by the Social Security Administration.
PIA is computed using your highest 35 years of wage-indexed earnings and then averages them. If you have less than 35 years of earnings. Then those years will calculated as being $0 to make up a total of 35 years. It all then averaged out and expressed as a monthly amount. That amount is your AIME, average indexed monthly earnings.
Applying your AIME to the PIA.
This is the next step. The PIA is a graduated percent of PIA benefit from the lowest earnings bracket up to higher earning brackets. The PIA formula has bend points which are like earnings segments. With the PIA formula you get 90% of your AIME for the first segment. It currently is the first $826 of your monthly AIME. Your next segment between $826 and $4,980 is at 32% of AIME. Any high earners with AIME amounts above $4,980 would then get 15% of their AIME last segment. For example. If your AIME is $2000. Then your PIA is $826 X 90% = $743 and $1174 X 32% = $375. Total PIA benefit is then $743 + $375 = $1118 per month.
What this formula does is build benefit progression into the system. Along with the Social Security Administration’s (SSA) special minimum benefit provision or auxiliary benefits.
The AGE you Claim, the final piece of the calculation.
Social Security uses an actuarial reduction factor. Most people know if you wait until your full retirement age of 66 and up, depending on your year of birth, you get your full benefit. Of which is figured as the above full PIA calculation. Claiming at the earliest possible age 62, your PIA amount is reduced by 25% for the rest of your life. In other words you only get 75% of PIA. Claim after your full retirement age you get a delayed retirement credit of 8% for each 12 month period you delay. Delay 1 year you get 108% of PIA. Delay 2 years your get 116% of PIA, etc. until age 70.
The actuarial reduction factor is based on the average mortality we have in our society for men and women on a combined basis. Along with interest rates that the SSA is operating under for discounting.
Cost of Living Adjustments (COLA).
Starting at age 62 COLAs are applied to your benefits whether you start claiming your benefit then or not. They are added year after year. Your later started claim will be automatically adjusted up with the higher COLA being added to it.
Understanding how Social Security is calculated when Retiring Early
The Impact of Retiring Early or having less than 35 years of earnings.
Depending on when you retire or perhaps you had extended periods of unemployment you may come up short of having a full 35 year earnings history where some years will be calculated as $0 income. Fortunately if your AIME is lower because of having less than 35 years of work your reduction is not proportionately reduced because your AIME is more focused on that lower end of the PIA formula that uses the 90% calculation. There is an impact but it will probably be in the 32% AIME segment. Another issue with retiring early is you are more likely dropping out of your highest earning years that would have taken the place of earlier low earnings years. This again will have some impact but also more likely in the 32% AIME segment.
The Positive Impact of Retiring Early and Often.
Ok, this is more about the possible positive impact to your Social Security when returning to work but I have to keep my pages aligned with what I am all about. Anytime you take on a new opportunity of interest or one that is aligned with your passions you have the opportunity for that earnings year to replace a lower or null earnings year out of your 35 used to calculate your benefit. Anytime you return to work your Social Security benefit can be recalculated upward.
You need to be aware of the rules associated to claiming your Social Security benefit at age 62 and then going back to work while collecting early Social Security. Your earnings will impact your benefit if you make over the threshold (about $15,000) and you are under your full retirement age. There is an earnings test for people before attaining age 66 – 67. Your benefit is reduced by $1 for every $2 of earnings above the earnings threshold until you reach your full retirement age.
If you happen to begin receiving your benefit at age 62 or any age before your full retirement age, return to work and get hit with the earnings test, your benefit reduction isn’t forever lost. This Early Social Security earnings test is not really a penalty or additional tax because it will all be calculated back into your benefit once you do reach your full retirement age.
Should Social Security be part of your long-term strategic retirement plan?
I say ABSOLUTELY YES. We paid into it for decades and played by all the rules. Big special interest dollars are trying to kill it or make it some kind of welfare while distracting everyone, enough so that any positive reform tweaks are being delayed. I am not going to EVER buy into that so for me I do include Social Security in my long-term strategic retirement plan.
Get your Social Security estimate and plug-in some recalculated figures in a retirement calculator I recommend, Firecalc. You can see how even a modest Social Security amount can have a major positive impact on your overall retirement funding requirements. You may even find that you can retire earlier than you thought.
I hope this page, Understanding how Social security is calculated has explained how America’s best retirement vehicle works and you can feel a little more informed about your Social Security benefit and your long-term strategic retirement plan.