Among the most popular Social Security questions that I hear from baby boomers getting ready to retire is "how are Social Security benefits calculated?" This is a vital question because it could affect how long you require to work, whether you should continue to work during your retirement years, or other aspects of your retirement plan.
Firstly, please note that you get a Social Security retirement benefit estimate every year in the mail, usually near your birth date. There are also a few calculators available on the Social Security website to help you estimate how much your retirement benefits will be, so you do not require to know the methods to calculate the benefit yourself.
It's still useful to know how Social Security is calculated, however, so here are the principles:
Basically, your top 35 years of earnings are indexed for inflation, then averaged to figure out the base for your per month benefit. If you worked less than 35 years, the missing years will be calculated as nothing for purposes of determining your benefit amount.
Planning tip: If you've close to 35 years of earnings and you are close to retirement, you'll benefit very much by continuing to work until you've 35 full years of earnings to include in your benefit calculation. The majority of people this will affect are females who took time off work to raise a family.
The top 35 years of earnings are then divided by 35 to arrive at your average indexed monthly earnings (AIME). A formula is applied to your AIME to figure out your primary insurance amount (PIA). We will not go into the details of the formula; the important thing to notice is that your PIA is the completely unreduced benefit you would receive if you retired at your full retirement age (age 66 for people born between 1943 and 1954). This amount will be decreased if you take early retirement or increased if you retire after age 66.
The Primary insurance amount is also the base for other benefits like spousal benefits, so it is significant to understand that your PIA is not always the same amount that you'll receive. If you're married and your spouse will be collecting benefits based on your earnings rather than her own, then you may need to maximize your own PIA to maximize the total Social Security benefits you and your spouse will receive.
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