How are Social Security Benefits Calculated?

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How are Social Security Benefits Calculated?

You are nearing retirement age and are wondering how much money you can expect from the federal government in Social Security benefits each month after you leave the workforce.

The short answer? The amount of money you earned while working determines your monthly benefits. Of course, it is not entirely that simple. The Social Security Administration also factors in inflation and other formulas to determine your final monthly benefit.

The length of your working career and how early you retire will also impact your monthly benefits.

Here's a closer look at what goes into determining the amount of money you will receive each month:

Your income

The Social Security Administration considers your 35 best working years -- the years in which you earned the most income -- when determining your monthly benefits.

It is important to note, though that the Social Security Administration might not use all of the income that you've earned during these years when calculating your monthly benefit if you are a high wage-earner. In 2023, for instance, every dollar that you earn above $160,200 will not count for Social Security benefits purposes.

You will also face income limits if you take Social Security benefits and continue to work between the ages of 62 and your full retirement age. Full retirement age is somewhere between the ages of 65 and 67, depending on your birth year. In addition, if you have not yet reached your full retirement age and earn more than $21,240 a year in 2023, then $1 will be deducted from your benefits for every $2 earned over $21,240.

The calculations

To determine your monthly benefit, the Social Security Administration takes the average of your 35 highest-earning years. That figure is adjusted for changes to average worker wages since the period in which you earned your money.

This is known as adjusting or indexing workers' earnings. This step makes sure that your future benefits reflect the rise in the standard of living that occurred during your years of working.

The Social Security system is also progressive in that lower-wage earners receive a higher percentage benefit than higher-wage earners do. The system returns a greater percentage of pre-retirement earnings to a lower-wage worker than to a higher-wage worker.

The Social Security Administration uses all this information to create your AIME, or averaged indexed monthly earnings. Eventually, the Social Security Administration calculates what it calls your Primary Insurance Amount or PIA. This is what you'll receive each month from Social Security.

Retirement age

Retirement age, though, has a big impact on the amount of Social Security benefits you receive each month. Simply put, if you retire too early, you'll earn less each month in benefits.

As of 2018, the earliest age at which you can begin collecting Social Security benefits is 62. However, if you choose to start receiving your benefits at this age, your monthly benefits amount will be reduced. There's a reason for this: The federal government figures that you'll be collecting your monthly benefits for a longer time if you retire at age 62. So monthly benefits are reduced for early retirees to make sure your payments equal out over your lifetime.

How much of a reduction will you face by retiring early? According to the Social Security Administration's website, main wage earners can expect to receive just 70 percent of their full monthly benefits if they retire at age 62 instead of 66 or 67. The spouses of primary wage earners will take an even bigger hit; they can expect to earn just 65 percent of their full monthly benefits if they retire at the age of 62.

The message seems clear: It makes more financial sense to begin collecting Social Security payments at or after full retirement age. Of course, even this matter is more complicated than it seems. If your health is poor, for instance, you might not live a long life after retiring. Collecting benefits early might make sense. Also, if you are out of work and can't find a new job, again it might make more sense to collect benefits earlier rather than later.

As you near retirement age, be sure to check for the Social Security benefits statements that the government has sent you since you turned 25. These statements list the amount of income you have declared each year and provide an estimate of how much Social Security money you can expect to earn each month depending on the day you retire.

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