How are Social Security benefits calculated?

How much retirement income you collect each month from Social Security will depend mainly on how much you earned during your working years and when you start receiving benefits.

The actual formula for determining a person’s monthly benefit is rather complicated. Below is an overview of how it’s done.

Adding up and indexing your earnings

Social Security begins with a record of how much you earned each year you were employed.

Each year’s earnings are multiplied by an indexing factor to make them nearly equivalent to what they would have been worth today. For example, the $10,000 annual salary a person earned in the mid-1970s would be close to the same as earning about $44,000 today.

The indexing factor allows the agency to put previous year’s earnings into amounts that reflect what they would be worth in today’s dollars. It ensures future Social Security benefits reflect the general rise in the standard of living that occurred during a person’s working lifetime.

The administration indexes an individual’s earnings to the nation’s average wage level two years prior to the year of first eligibility, which for most people is age 60.

Therefore, the indexed factor equals 1 for the year you reach age 60 and all subsequent years. So if you earned $50,000 the year you turned 60, your indexed earnings would also equal $50,000. If your earnings dropped to $48,000 at age 61, your indexed earnings would also equal $48,000 for that year.

The index factor for the years before turning age 60 is a bit complicated.

Each person’s index factor is calculated using the average wages in the country subject to federal income taxes in the year the participant turned 60.

In 2014, the average wage index was $46,481. It was $44,888 in 2013, and $44,321 in 2012.

To then determine the index factor for an individual for a particular year, the average wage index in the year he or she turned age 60 is divided by the average wage in that year.

For example, the average wage index in 1992 was $21,811. For an individual who turned 60 in 2012, the index factor would be determined by dividing $44,321 by $21,811, which equals 2.03.

So assume a person who turned 60 in 2012 earned $26,000 in 1992. His or her indexed earnings for that year would be $52,780 (26,000 x 2.03). Essentially, Social Security has determined the taxable income this person earned in 1992 is equivalent to $52,780 earned in 2012.

The administration does this calculation for every year you earned taxable income. It then adds the 35 highest annual totals after indexing and divides that number by 420, which equals how many months are in 35 years.

Determining how much you made per month

That number is officially called your Average Indexed Monthly Earnings (AIME). It is basically the average amount of money you earned over your most lucrative 35 years, expressed in the inflation-adjusted amount that corresponds with the year you turned 60.

If you don’t have taxable income in at least 35 years, the administration assigns $0 for as many years under 35 that you didn’t earn income. For example, if you earned income in 30 years, the administration would assign you $0 in earnings for five years to get to 35 years.

Determining what you monthly benefit should be

The next step is to calculate a Primary Insurance Amount (PIA), which is the benefit a person would receive if he or she started receiving benefits at normal retirement age.

Normal retirement age for people born between 1943 and 1954 is 66. It increases two months for every year a person is born after 1955; a person born in 1956 has a normal retirement age is 66 years and four months. Those born 1960 or later have a normal retirement age of 67.

The PIA is a complicated formula that takes the sum of three separate percentages of portions of the AIME. For a person who turned age 62 in 2012, those portions, also known as bend points, are the first $767, the amount between $767 and $4,624, and the amount over $4,624.

For people who reached age 62 in 2012, their PIA is the sum of:

90 percent of the first $767 of his/her average indexed monthly earnings, plus

32 percent of his/her average indexed monthly earnings over $767 and less than $4,624, plus

15 percent of his/her average indexed monthly earnings over $4,624.

So if a person’s AIME is $6,500, their PIA would be the sum of:

90 percent of $767, which is $690.30

32 percent of $3,857 ($4,624 – $767), which is $1,234.24

15 percent of $1,876 ($6,500 – $4,624), which is $281.40

The total PIA is $690.30 + $1,234.24 + $281.40, which equals $2,205.94.

In 2016, this person reached normal retirement age, so he or she could start receiving Social Security benefits and be entitled to a monthly benefit that first year of $2,205.94.

If the person started receiving benefits before normal retirement age, the monthly benefit would be decreased by a percentage based on when they started benefits. If the recipient waited until after normal retirement age, the monthly benefit would be increased by a percentage based on when that occurred.