How Are Social Security Benefits Calculated?

Social Security benefits can be an important source of income after you retire. With the right planning, this income can help you live your best life throughout your retirement. To help you choose the best time to retire, you can estimate Social Security benefits and the taxes you might pay on your benefits in the future.

Social Security benefits are not one size fits all. So how are Social Security benefits calculated? They are calculated based a variety of factors, like the age you begin claiming them. The Social Security Administration (SSA) averages the wages you earned over the 35 years your income was highest and adjusts for inflation. Once your average has been determined, the SSA uses the following factors to determine what you’ll receive.

Factor #1: Your Average Indexed Monthly Earnings.

First, the SSA takes your 35 highest-income amounts, applies it to the national average wage index (NAWI) to account for inflation,¹ and then determines your average earnings over the course of your career. If you didn’t work for a full 35 years, the SSA will count the years you didn’t work at $0.² This calculation is called your average indexed monthly earnings, or AIME.³

Factor #2: Your Primary Insurance Amount.

Get ready for acronyms. After the SSA calculates your AIME, it breaks the figure into three parts, applying a formula to calculate your primary insurance amount, or PIA.³ The three amounts are called “bend points,” because the formula, when shown on a graph, appears as a series of line segments that meet at these amounts.⁴

Your bend points are determined by the SSA the year you turn 62, regardless of how old you are when you start collecting benefits. Here’s the percentage of each bend point you will receive:³

• 90% of your AIME up to a first bend point
• 32% of your AIME up to a second bend point
• 15% of your AIME for the remainder of your income

These bend points are income limits, or maximum income levels. They change from year to year based on changes to the NAWI, but the percentage of AIME used to calculate PIA always stays the same.⁵

It’s a lot to take in, so here’s an example: Let’s say that in 2019, your first bend point was $926 and the second was $5,583. Therefore, someone turning 62 in 2019 who is eligible to collect their full benefits would get:⁵

• 90% of their AIME up to $926
• 32% of their AIME above $926 but below $5,583
• 15% of their AIME above $5,583

When Can I Collect Full Social Security Benefits?

It’s important to remember that you can only receive full Social Security benefits if you retire at your full retirement age (FRA). Your FRA varies, depending on the year you were born. Check the SSA website to see your exact FRA.

While you can receive Social Security benefits as early as age 62, keep in mind that your payments will be reduced — permanently. If you retire 36 months or less before your FRA, benefits are reduced by 5/9 of 1% per month. If you retire more than 36 months before FRA, benefits are reduced by an additional 5/12 of 1% for each prior month.⁶ It doesn't sound like much, but these reductions can add up: For those with a FRA of 67, benefits would be reduced by 30% if retiring at age 62.⁷

On the other hand, if you delay retirement until after your FRA, your benefits will increase by 2/3 of 1% each month but then stop increasing once you turn 70. However, if someone with an FRA of 67 retires at 70, they could see a 24% increase in monthly benefits compared to retiring at 67.⁷

How to Calculate Taxes on Social Security Benefits.

As they say, the only certainty in life is death and taxes. If your income exceeds a certain threshold, you will have to pay federal taxes on your Social Security benefits. In this situation, your income is calculated by adding up your ordinary taxable income, self-employment income, non-taxable interest, and half of your Social Security benefits.⁸

Let's break it down: If your ordinary taxable income is $20,000, you have no nontaxable interest income, and your Social Security benefits are $15,000 per year, then your income for purposes of determining taxes on your benefits would equal $27,500 ($20,000 + 1/2 of $15,000).

You’ll need to pay federal taxes on Social Security benefits if your income in this circumstance exceeds $25,000 if you're filing as an individual or $32,000 for married filing jointly.⁸

How Much of My Social Security Is Taxable?

The percentage of your Social Security benefits subject to tax is determined by your income and filing status.⁸

Income filed as an individual:

• $25,000 to $34,000 — pay taxes on up to 50% of your benefits
• More than $34,000 — pay taxes on up to a maximum of 85% of benefits

Income of married couple filing jointly:

• $32,000 to $44,000 — pay taxes on up to 50% of your benefits
• More than $44,000 — pay taxes on up to a maximum of 85% of benefits

IRS Publication 915 explains how to calculate taxes owed on your benefits.⁹ But don’t worry, most tax filing programs will do these calculations for you, as will professional tax preparers.

In addition to federal taxes that you might need to pay, as of 2019, there are currently 13 states that tax Social Security benefits. Each state has its own formula for determining tax rates, so if you live or plan to live in one of these states, be sure to learn what your tax rate will be when doing your retirement planning.¹⁰

• Colorado
• Connecticut
• Kansas
• Minnesota
• Missouri
• Montana
• Nebraska
• New Mexico
• North Dakota
• Rhode Island
• Utah
• Vermont
• West Virginia*

*Currently changing how it taxes Social Security benefits.¹¹

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