One of 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 significant question as 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.
First, please note that you receive a Social Security retirement benefit estimate each year in the mail, usually around your birth date. There're also a few calculators available on the Social Security website to help you estimate how much your retirement benefits will be, so you don't need to know how to calculate the benefit yourself.
It's still helpful to know how Social Security is calculated, but, so here are the principles:
Basically, your top 35 years of earnings are indexed for inflation, then averaged to determine the basis for your monthly benefit. If you worked less than 35 years, the missing years will be calculated as zero for purposes of determining your benefit amount.
Planning suggestion: If you've close to 35 years of earnings and you are close to retirement, you will benefit greatly by continuing to work until you have 35 full years of earnings to include in your benefit calculation. The majority of people it 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 determine your primary insurance amount (PIA). We won't go into the specifics of the formula; the significant thing to note is that your Primary insurance amount 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 reduced if you take early retirement or increased if you retire after age 66.
The PIA is also the basis for other benefits such as spousal benefits, therefore it is significant to understand that your PIA is not necessarily the same amount that you will receive. If you are married and your spouse will be collecting benefits based on your earnings instead of her own, then you might need to maximize your own PIA to maximize the total Social Security benefits you and your spouse will get.
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