How Social Security is Actually Funded and Calculated

 In this episode of The Retirement Guide, George Jameson, CFP® and founder of Capital Wealth Group in Columbia, SC explains how Social Security is funded and calculated and some advice on the best time to start your benefits. 

 Welcome to "The Retirement Guide" Podcast! I'm your host George Jameson, owner of Capital Wealth Group, a Fee Only Advisory firm. Whether you’re nearing retirement or already retired, Join me each week as we explore the world of retirement planning and equip you with the knowledge and tools you need for a successful retirement.

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This is for education only.It is not tax, legal, or investment advice. Before  acting on any information consult your tax, legal, or investment advisor.

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Transcript

George Jameson, CFP®: 0:19

I'm George Jamison, certified financial planner and founder of Capital Wealth Group, a fee only firm based in Columbia, South Carolina. And today we're exploring social security. So social security is one of the cornerstones of retirement planning, yet many of us aren't completely sure how it works or how we can maximize the benefits. In this episode, I'll walk you through how Social Security is funded and the unique way it calculates your benefits. And then my following episode, I will share five actionable strategies. That may help boost your monthly check in retirement. So now let's look at how Social Security is funded and calculated. First, social Security is funded through payroll or FICA taxes, or part of FICA taxes. If you're a W2 employee, you contribute to social security through FICA taxes. You pay 6.2% of your income up to a cap of 176,100 for 2025. Your employer also contributes 6.2% of taxes up to the same salary cap 176,100. In other words, both you and your employer are contributing to your future Social Security benefits for a total of 12.4% tax. If you're self-employed, you pay the full amount, but that's for another discussion. The ceiling on income subject to these taxes rises each year. For example, in 1993, the maximum subject to FICA taxes was only 57,600. Now that you know how Social Security is funded, let's look at how your benefits are determined. First, your earnings are indexed each year. Since wages and prices have risen over time, earnings from past years need to be adjusted to reflect current wage levels. This is called indexing. So the Social Security Administration uses an average wage index to adjust your past earnings. This index reflects the general increase in wages since the year that you earned the money Indexing ensures that your earlier lower dollar incomes are fairly considered in today's terms when calculating your benefits. After indexing your earnings, the Social Security Administration looks at your highest 35 years of earnings. If you've worked fewer than 35 years, the years with no earnings are counted as zeros. Keep that in mind. And third, once your highest 35 years of earnings are indexed, they are then all added up. This total is then divided by 420, the number of months in 35 years to calculate your average index monthly earnings, also called AIME AIME. AIME is the foundation for calculating your primary insurance amount. You'll also see the acronym PIA. This amount is your estimated benefits, assuming you start Social Security at your full retirement age. FRA is currently age 67 if born on or after 1960, next, the PIA is not a simple percentage of your AIME. Instead, it is calculated using a formula, what's called bend points. These bend points create a progressive benefit structured to help lower income workers. The bend points start at 90%. And then 32% and then finally 15%. I know this sounds complicated and it's good to know, but you do not actually need to know how to do all the calculations, of course. But let's look at a simplified explanation just for those who are curious. Let's say Sarah is retiring in 2025 and the Social Security Administration calculates her AIME at 6,000. Then we'll need to calculate her PIA, which remember the PIA stands for primary insurance amount and really PIA is your benefits at your full retirement age. So the first bend point you, you calculate again is 90%, and for 2025 you calculate 90% on the first$1,226 of the AIME. So 0.9 times 12, 26 equals$1,103. And then the second bend point you calculate, is 32% of your AIME between$1,226 and$7,391. However, for Sarah, her AIME is only 6,000, so we do 6,000 minus 1226, which equals$4,774. So we multiply that by 0.32 to get approximately$1,528. Again, since Sarah's AIME was 6,000, we don't need to calculate the third Bend point. So Sarah's projected PIA using official 2025 figures. Is the sum of 1103 plus 1528, which comes out to be approximately$2,631. So now let's look at one more example. Let's say Michael has an AIME of 9,000 and he is 67 and he's retiring in 2025. His first bend point, again, is the same as Sarah's, 90% of the first$1,226, which equals 11.03. And then second bend point is 32% of AIME between$1,226 and$7,391. So you do 7,391 minus 1226, which equals$6,165, and we multiply that by 0.32 to get approximately 1,973. Michael has an of$9,000. We'll also calculate the third bend point, which is 15% of AIME, anything above$7,391. So we do 9,000 minus 73 9 1, which equals 1609, and we multiply that by 0.15, which gets him an extra$241. So now we sum up all three calculations. The 1103. 1973 and the 241, and it gives him approximate$3,317 for his monthly benefits, assuming he's 67 and retired in 2025. So let's review how social security benefits are determined. First, your work history and earnings and then number two, indexing past earnings for wage growth. And then three, focusing on your highest 35 years of earnings. And four, calculating your AIME from those earnings. And then finally using a progressive bend point formula to calculate your actual PIA primary insurance amount. And then six, adjusting your PIA based on your retirement age. How to get your own benefit estimate. I highly recommend going to my social security account, and the best way to get an accurate estimate for your future benefits is to create a my social security account@ssa.gov. You can view your earnings records to make sure they're accurate, and again, you don't need to know how to calculate all of this. Definitely want to make sure your earnings are correct on the website. So I hope this sheds some light on how social Security works. Next week will be about maximizing social security benefits and the best time to start. Hope everyone has a great day.