Among the most popular Social Security questions that I hear from baby boomers getting prepared for 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 need to continue to work during your retirement years, or other factors of your retirement plan.
Firstly, please note that you receive a Social Security retirement benefit estimate every year in the mail, generally around your birth date. There are also a few calculators available on the Social Security web site to help you estimate how much your retirement benefits will be, thus you do not need to know the methods to calculate the benefit yourself.
It is still useful to know how Social Security is calculated, however, so here are the principles:
Mostly, your top 35 years of earnings are listed for inflation, then averaged to figure out the basis for your per month benefit. If you worked lower than 35 years, the missing years will be calculated as zero for purposes of determining your benefit amount.
Planning tip: If you've near 35 years of earnings and you are near to retirement, you'll benefit greatly by continuing to work until you've 35 full years of earnings to include in your benefit calculation. Most of the people this will affect are females who took time off work to raise a family.
The highest 35 years of earnings are then divided by 35 to arrive at your average indexed monthly earnings (AIME). A formula is applied to your Average indexed monthly earnings to figure out your primary insurance amount (PIA). We won't go into the details of the formula; the crucial thing to note is that your PIA is the completely unreduced benefit you'd receive if you retired at your full retirement age (age 66 for people born between 1943-1954). This amount will be decreased if you take early retirement or increased if you retire after age 66.
The PIA is also the base for many other benefits such as spousal benefits, so it is crucial to understand that your PIA isn't always the same amount that you will receive. If you're married and your spouse will be collecting benefits according to your earnings instead of her own, then you may need to maximize your own Primary insurance amount to maximize the total Social Security benefits you and your spouse will obtain.
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