October 19, 2013

MinistryCPA Special Topic: Social Security Benefit Calculation (Part 1 of 2)

Question:

Having just turned 60, I am in the process of planning my retirement, so I would like to get an idea of how much I can expect for Social Security benefits each month. Can I simply apply a percentage to my average monthly wages over my working life to get an estimate? If not, how does the Social Security Administration calculate my monthly benefit?

Answer:

Unfortunately, the process is more complicated than that; you can access a monthly benefit projection by creating an account on the SSA website. Benefits are based on Social Security earnings; that is, only earnings that have been subject to Social Security tax are used in the calculation of benefits. Additionally, the SSA uses a number called averaged indexed monthly earnings (AIME). This number is important in that it forms the basis for calculation of monthly benefits. 

AIME is calculated based on the 35 highest years of Social Security earnings for an individual. For example, an individual born in 1948 whose earnings grow steadily each year from 1966-2015 will not have an AIME based on the full 50 years, but on the highest 35. At first glance, it seems obvious that the most recent years will be the highest; however, the SSA introduces one more variable. Each year's earnings (for example, 1976) are indexed (multiplied by a factor based on average wages for 1976 compared with the year the individual turns 60-in this case, 2008). This essentially converts 1976 wages to 2008 dollars. Any wages this individual earns after 2008 will not be indexed. 

Once each eligible year has been indexed, the top 35 wage years are added together and divided by 420 (the number of months in 35 years). The resulting number is the individual's AIME, which will then be used to calculate benefits. In our next post on Social Security, we will discuss calculation of benefits using AIME.

As is the case with our other posts on this topic, individuals who are disabled or eligible for survivor's benefits may be subject to different guidelines.

For more on this topic, visit the AIME page on the SSA website.

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