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So, How Does Social Security Calculate My Monthly Benefit?

One of the more frequently misunderstood items our AMAC Foundation Social Security Asdvisors encounter is the belief that retirement benefits are based on one’s last 5 years of earnings. Some say the last 10 years, and some even maintain that the replacement rate—that is, the portion of your earnings that will be replaced by Social Security—is based on your last full year of reported earnings. None of these scenarios are true, or even close to the reality of how benefits are determined.

Here’s how it actually works. Each year after your federal income tax return is filed, the IRS forwards your earnings record to the Social Security Administration (SSA), where the information is stored in your individual work record. If you had no earnings on which you paid Social Security tax (called payroll tax or, officially, FICA tax), your recorded earnings would be zero for that year.

When you reach age 62, SSA takes all of the years of earnings information in your work record and indexes them to adjust for inflation. This indexing process, which is designed to equate your historical earnings to present-day values, uses the National Average Wage Index for the year you turned 60 and compares this factor to each year of your earnings to ensure that the prior years take inflation into consideration. (The earnings between age 60 and 62, incidentally, are taken at face value.)

Here’s an example of the math: someone born in 1962 and earned $21,986 in 1992 would have their 1992 earning multiplied by 2.78, meaning they would be equal to $61,121 in current dollars.

So, after indexing all the records in your work history, SSA then adds them together and selects the highest 35 years of indexed earnings. These highest 35 earnings figures are then added together and divided by 420—the number of months in 35 years—to produce an average monthly figure, referred to as AIME, or your Average Indexed Monthly Earnings.

That completes the first major step in the process, but it’s not over yet. The next step is to calculate your Primary Insurance Amount (PIA), which is the benefit a person would receive if he/she elects to begin receiving retirement benefits at his/her normal retirement age. To determine PIA, SSA takes your AIME figure and breaks it into three segments, with each segment multiplied by a different percentage.

Your PIA will be the sum of:
(a) 90 percent of the first $1,174 of your average indexed monthly earnings, plus

(b) 32 percent of your average indexed monthly earnings over $1,174 and through $7,078, plus

(c) 15 percent of your average indexed monthly earnings over $7,078.

Here’s an example of the math, using a hypothetical AIME of $8,000:

               First segment: $1174 * 90% = 1056.60)

               Second segment: ($7078 minus $1174 = $5904; $6826 * 32% = 1889.20)

               Third segment: ($8000 minus $7078 = $922; $922 * 15% = 138.30

(Each of the results above are rounded to the next lowest 10 cents)

Hypothetical PIA Calculation (AIME = $8000)
AIME  Segment%Calc. Amt.Benefit Portion
$8000$0 – $1,17490%$1,174$1056.60
$7,078 – $1,17432%$5,904$1889.20
Over $7,07815%$922$138.30
Rounded PIA$3084

At this point, the pieces are added together to almost become your Primary Insurance Amount. I say almost, because there’s one step left, and that is to round the calculated amount down to the lowest whole dollar. So, in the example shown here, the calculated PIA would be rounded down to $3084.

In terms of income replacement rates, note also that this example illustrates a replacement rate of 38.6%.

Here’s another example, using a lower AIME:

Hypothetical PIA Calculation (AIME = $5,321)
AIME  Segment%Calc. Amt.Benefit Portion
$5,321$0 – $1,17490%$1,174$1,056.60
$5,321 – $1,17432%$4,147$1,327.00
Rounded PIA$2,383

In this example. There are only two segments in the PIA calculation because the second segment is less than the $7,078 applicable to that segment, and of course there is no third step in the calculation. Note also that the replacement rate 44.8%, illustrating the progressive nature of Social Security benefits.

This explanation is brought to you as a service of the AMAC Foundation. Learn more about our free-to-the-public Social Security Advisory Service here.

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