A Feeling Of Security
When I got my first job in high school, I looked at my paycheck and was astonished at how much money was taken out for taxes. The federal taxes were not surprising, nor were the state taxes. What I did not expect to see was the line item labeled “FICA.” FICA stands for Federal Insurance Contributions Act. FICA taxes are paid into the Social Security and Medicare systems and allow individuals to earn credits towards receiving benefits later in life. Many folks take the Social Security system for granted. It’s been around since 1935, when President Roosevelt signed the bill. It is meant to replace a portion of your income at retirement. Until the 1980s, pensions were still very popular and often provided the remainder of retirement income. Since the establishment of the 401(k) in 1978, the way people plan for retirement has changed, and so has Social Security’s role within retirement planning. This month’s article will provide a detailed look at how an individual’s Social Security benefit is calculated.
Top 35 Years of Earnings
Retirement planning is all about income replacement. After looking at a person’s anticipated retirement expenses, the next question becomes how to pay for these expenses once the individual’s salary has stopped. Social Security benefits are a part of this income replacement formula. The monthly benefit at retirement is calculated based on a person’s top 35 years of earnings. The Social Security Administration (SSA) keeps a record of every employed person’s earnings each year. As a person works and pays FICA taxes, their salary for the calendar year is recorded. Since inflation changes the real value of money, earnings are indexed for inflation each year they are recorded. This means each year’s earnings are adjusted so they have the same real dollar value as all of the other years. When a person retires and is ready to start receiving their benefit, the SSA takes the real dollar value of the highest 35 years of earnings and uses those values to figure out a person’s average indexed monthly earnings (AIME).
The AIME Calculation
Tom has a reliable job with a steady salary. Every year for the last 35 years, he has earned $75,000 in real terms. Here is the process that the Social Security Administration (SSA) follows to determine Tom’s monthly benefits:
First, the SSA will add up the total amount of real dollars earned over the 35 highest-earning years: $75,000 x 35 = $2,265,000
Next, the SSA will divide the total by 420, which is the total number of months in 35 years: $2,265,000 / 420 = $6,250
$6,250 is Tom’s average indexed monthly earnings (AIME). This is the figure that will be used in the remainder of his benefit calculation.
The Three Tiers
Unfortunately, the Social Security benefit is not the entire amount of the AIME. The AIME is then broken down into three tiers. The Social Security monthly benefit is meant to replace:
90% of the first $791 of the AIME
32% of any AIME amount over $791 but below $4,768
15% of any AIME amount of $4,768 up to the benefit cap
So, using Tom’s AIME of $6,250, his full retirement age benefit would be calculated as follows:.9 x $791 = $711.90 + .32 x $3,997 = $1,279.04 + .15 x $1,482 = $222.30$711.90 + $1,279.04 + $222.30 = $2,213.24 per month
Check Your Statement Regularly
It is important to check your Social Security benefits statement regularly. A person can check their statement by visiting www.socialsecurity.gov/mystatement. Keep in mind that the benefit estimate on the second page of the statement is based on the years of earnings already on the books as well as the assumption that an individual will continue to earn the same amount between now and full retirement age.
Increasing the Monthly Benefit
It is possible for a person to increase their anticipated Social Security benefit by increasing their income in the later years of their working life. A higher salary recorded with the SSA means a higher AIME calculation, which means a larger benefit. However, please keep in mind that once a person has earnings that surpass $4,768 in AIME, each additional dollar added to the AIME only results in $0.15 of additional monthly benefit, up to the benefit cap. So it can be hard to move the needle.
One Piece of the Puzzle
For people of greater means, Social Security benefits often replace a smaller portion of their expected retirement income. Since Social Security benefits are only one piece of the puzzle, it is essential to speak with your financial planner about your anticipated retirement expenses and your plan for replacing your income with other sources, such as investment income and Social Security benefits. If you have not visited this subject in recent years, I suggest we get together to chat.
This commentary reflects the personal opinions, viewpoints, and analyses of The Dala Group, LLC employees providing such comments. It should not be regarded as a description of advisory services provided by The Dala Group, LLC or performance returns of any The Dala Group, LLC client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this commentary constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. The Dala Group, LLC manages its clients’ accounts using various investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
