I had a great chat with my mom the other day.  Of course, they’re always great chats.  Every once in awhile, as happened the other day, the topic turns to finance.  On this particular day, we talked about Social Security.  We’re pretty exciting like that.  Mom’s concern?  Many people don’t understand the options and choices that come with taking Social Security.  Is it automatic?  When should I start?  Why are my benefits reduced while I’m working?  What is “Full Retirement Age?”  For the next few weeks on Money Monday we break it down and make it easier to understand.

First, what exactly is Social Security?  Social Security is a government program which pays retirement benefits to qualified individuals.  To be qualified, you have to earn credits.  Each quarter you meet minimum earnings ($1,260 in 2016) you earn a credit.  Anyone born after 1929 needs 40 credits (10 years of work) to be eligible to receive Social Security benefits.  The amount of benefit you receive is based on your earnings history so it’s important to verify the accuracy of that information.  You can easily do that by creating an account on SSA.gov and follow the links to your earnings history.  Once you’re satisfied the history is correct, these are the earnings you’ll use in the worksheet above to estimate your monthly Social Security benefit.

The Social Security Administration (SSA) averages your highest 35 years of earnings, indexed for inflation, to calculate your benefits.  If you work less than 35 years, your total lifetime earnings will still be divided by 35 to get an average.  To show it in real numbers, let’s say you work 20 years at a salary (indexed for inflation) of $40,000 each year.   As a true average you take 20 years X $40,000 per year = $800,000 lifetime earnings.  Divide those earnings by the 20 years worked = an average salary of $40,000.  Pretty straightforward.

Social Security calculates your average differently: 20 years X $40,000 per year = $800,000 lifetime earnings.  Divide those earnings by 35 = $22,857.  Those are your average earnings for Social Security purposes.  But look what happens if you work an additional 5 years at $40,000:  25 years X $40,000 per year = $1,000,000.  Divide that by 35 and you have an average of $28,571.  That’s an increase of $5,714 annually.  The obvious example would be earning $40,000 each year for 35 years: 35 X $40,000 = $1,400,000.  Divide that by 35 = $40,000.  In that situation, SSA would use $40,000.  Clearly, working 35 years makes a difference.  (Making more per year would also make a difference.)

We see how SSA arrives at an average. How does this amount translate into Social Security benefits?  SSA provides an estimated benefits statement to eligible recipients.  They once were mailed annually but it’s much less often now.  You can see your benefits statement on SSA.gov.  You can also estimate your benefits using the SSA worksheet here.  This particular worksheet is designed for someone born in 1954.  As a result, if you were born before or after that date you can use the worksheet but actual results will differ a bit.  There are other calculators within the website to estimate benefits for those born in different years.  Also important to note: benefits are adjusted if you take Social Security at a time other than your Full Retirement Age (FRA), which is generally thought of as “normal” retirement age.  FRA is 65 if you were born before 1938 and gradually increases to age 67 for those born between 1938 and 1959.  We’ll talk about the significance of this age  next week. For now, let’s talk about how your benefits are calculated.

SSA takes your highest 35 years of earnings, adjusted for inflation, and divides that total by 420 (the number of months in 35 years).  Let’s use the amounts from the previous example to show how it’s done.  First, we take the 35-year average and convert it to a monthly amount:$800,000/420 = $1,904, rounded down to the next lowest dollar. (420 is the number of months in 35 years.)  Take the first $856 of that amount and multiply by 90%, to get $770.40.  Take the number we just calculated, $1,904, and subtract $856, to arrive at $1,049.  Multiply that amount by 32% to get 335.60 and add those numbers together; the result is $1,106.00.  This is your estimated monthly benefit if you retire at your FRA.   If you work those extra 5 years for lifetime earnings of $1,000,000 and run through the math, your estimated monthly benefit is $1,258.  That’s an increase of $152/month or $1,824/year.

Again, the calculated amount will be the amount you can expect to receive at Full Retirement Age and it changes if you choose to receive benefits at a different age, as we’ll discuss next week.  Also, your calculation will be slightly different if your 35-year average is greater than $5,157.  Rather than taking your 35-year average, subtracting $856 and multiplying the difference by 32%, you’ll use $5,157 -$856 = $4,301, multiply that number by 32% and arrive at $1,376.32.  The amount over $5,157 is multiplied by 15%.  That result + $1,376.32 + 770.40 = your estimated monthly benefit at your FRA.

As you’ve seen, a lot goes into the calculation of your potential monthly Social Security benefit.  There are several ways to change the amount you’ll receive.  We’ve seen how you can increase your benefit by working more years or earning more each year.  If you’ve had a lean season, you can recover by working more than 35 years, replacing those low-income years with years of more robust earnings.  Remember, SSA takes your highest 35 years’ earnings.

Be sure to check out next week’s Money Monday post.  We’ll discuss other ways you can increase your monthly SSA benefits.

To your better wealth,