A brief primer on social security benefits
June 18, 2018
By Anthony Kaylin, courtesy of SBAM Approved Partner ASE
Given that 10,000 Baby boomers retire every day, employees may be coming to HR for help determining when to retire and what benefits will be available to them. They will likely inquire about how Social Security benefits are determined.
Generally, best practice would be to have the 401(K) provider provide the training, but that option may not always be available, and HR is expected to know it all. The following is a quick explanation of how Social Security benefits are calculated.
The Social Security Act was enacted August 14, 1935. To support social security, the federal government instituted a tax on employers and employees. Currently the FICA tax (Federal Insurance Contributions Tax) is 12.4% for Social Security and paid equally (6.2%) by the employer and employee on gross earnings. There is a cap on earnings that can be taxed. In 2018 the cap is $128,400.
To be eligible for Social Security, a worker must work 40 quarters or 10 years minimum. In the 1980s when a deficit was identified by the Board of Trustees, Congress passed a law that changed the ages for workers when they would be entitled to full Social Security:
Year of Birth*
Full Retirement Age
1937 or earlier
65 and 2 months
65 and 4 months
65 and 6 months
65 and 8 months
65 and 10 months
1943 – 1954
66 and 2 months
66 and 4 months
66 and 6 months
66 and 8 months
66 and 10 months
1960 and later
*If a person was born on January 1st of any year they should refer to the previous year. Source: Social Security Administration (SSA)
To calculate the Social Security payment at full retirement age, first the average indexed monthly earnings (AIME), must be determined. To calculate the AIME, the SSA takes each year of earnings throughout the employee’s working lifetime, up to the Social Security taxable maximum. Then, each year’s earnings are adjusted for inflation, or “indexed.” The formula uses the 35 highest years of earnings (based on the employee’s reported earnings in the tax return) to determine the AIME. Then the calculation is done by adding all 35 years of indexed earnings together, dividing by 35 to find the annual average, and dividing this result by 12 to determine the lifetime monthly average.
Therefore, every year a higher salary is earned, once 35 years of working is achieved, it takes the place of a low salary year, for example, wages earned while a student.
To determine the actual benefit, the average indexed monthly earnings (AIME) are then used to determine the basic Social Security retirement benefit. This calculation is called the primary insurance amount, or PIA, which determines the payment amount.
To determine the PIA, AIME is applied to a formula. For example, in 2018 the formula for full benefits is:
- 90% of the first $895 in AIME
- 32% of the amount of AIME greater than $895, up to $5,397
- 15% of the amount of AIME greater than $5,397
These percentages stay the same each year, but the thresholds or bend points may change, depending on the year and age of retirement. The earlier a person retires, the lower the bend point.
Further, if a worker decides to claim Social Security before reaching full retirement age, the benefit amount calculated by the previous steps will be reduced at a rate of 0.56% per month (6.67% per year) for as many as 36 months before reaching full retirement age, and at a rate of 0.42% per month (5% per year) beyond 36 months early, until as early as age 62. In other words, if the employee retired at age 62, the monthly benefit amount is reduced by about 30%. The reduction for starting benefits at age 63 is about 25%; at 64 is about 20%; at 65 is about 13.3%; and 66 is about 6.7%.
On the other hand, if an employee waits until after full retirement age to collect, the retirement benefit will be permanently increased at the rate of 0.67% per month (8% per year), and this delayed retirement credit can continue to accumulate until age 70. In addition, employees after the age of 66 has no cap on earnings while collecting Social Security.
If an employee collects Social Security before reaching age 66, the employee can only earn up to $16,920 income limit. After that, Social Security will further reduce the amount received in Social Security income by $1 for every $2 dollars you earn above next year’s income limit. Social Security will withhold overage amount by withholding each month’s payment until the overage is covered. Once the overage is met, the payments will continue. Any excess withholdings will be returned to the employee in the next year.
Finally, Social Security is subject to federal taxation (as well as in some state jurisdictions).
There is concern about whether Social Security would be solvent in later years given less workers are feeding into the trust fund. Social Security’s total income is projected to exceed its total cost through 2021. After 2021, interest income and redemption of trust fund asset reserves from the General Fund of the Treasury will provide the resources needed to offset Social Security’s annual deficits until 2034. After that time, it is projected by the Social Security and Medicare Boards of Trustees that FICA should be sufficient to pay about three-quarters of scheduled benefits through the end of the projection period in 2091.
Unless another baby boom occurs, Congress will likely impose another fix. This could include increasing the age for full benefits to edging up the tax rates, which the Trustees project to be approximately 2%.