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Social Security is a valuable resource for older and disabled workers as well as the worker’s survivors and dependents. It provides 90% of the cash flow for one-third of retirees. It delivers 28% of the cash flow for high income retirees. A mistake in claiming these benefits can be permanent and costly to the worker and his/her family. This is the second in a series of articles on Social Security. The objective of the series is to help you make better decisions regarding claiming benefits. To make good decisions we need to identify, determine, and appreciate certain terms and concepts. The theme of this installment is the procedure used to calculate Social Security benefits and a brief discussion of average benefits. Estimating your benefits is the essential first step in the SS decision-making process. Fortunately, there are number of free and commercial online calculators that will generate rough estimates of your benefits. To obtain the proper results from the calculators and to maximize your return from the taxes paid, you should understand how the benefits are determined. The Social Security Administration provides valuable assistance with the SSA’s annual statement of benefits, over-the-phone estimates (800/772-1213), in-person estimates at a local SSA office and several free online calculators. The best starting point for SS planning is to establish an account using the website, SSA.GOV/myaccount. The SSA’s statement is an indispensable tool providing a summary of a worker’s historical earnings and estimates of projected benefits. The SSA statement provides you with the information to facilitate the use of the planning calculators. The benefit formula is a bit mind-numbing; this article will focus on the pertinent facts that you need to know to make better decisions.

Progressive or Regressive?

Is our Social Security program progressive or regressive? This is a curious question. A progressive tax structure is one in which the rate increases as the payer’s income increases. It favors lower income individuals. Taxpayers who earn higher incomes pay a greater proportion of their income as tax. A regressive tax is one whose rate decreases as the payer’s income increases. With a regressive rate structure higher income taxpayers pay a smaller average percentage of their total income in tax than lower income individuals. In 2018, workers in the United States pay 6.2% in Social Security taxes on active income (wages and business income, non-investment income) earned up to $128,400. The wage ceiling is adjusted annually for inflation. Employers pay in at the same rate and on the same base. Self-employed individuals pay both their share and the employer’s portion or 12.4% in total. Therefore, a worker earning $128,400 pays $7,961 in SS taxes. Medicare taxes are also paid by employees, employers, and self-employed individuals, but this is a subject for another article. A worker who makes $249,000 in 2018 pays $7,961, which is an average rate of 3.2% or one-half the rate of workers who earn less than the base wage. This example illustrates why many economists describe Social Security as a regressive tax structure. This article will focus on retirement benefits, and we will see if Social Security benefits are progressive.

The Social Security Benefit Formula

The Social Security Administration calculates a worker’s benefits using a multipart formula. Your covered lifetime earnings record is very important. As noted earlier, it is first a good idea to establish an account using the SSA site. You should check the reported earnings periodically during your working career to confirm that it is correct. Errors are sometimes made and these errors can significantly distort your benefits. Mistakes made in your recent history are easier to fix than those made many years ago.

A key term in the benefit calculation process is AIME, Average Indexed Monthly Earnings. The annual income used is the lower of what the worker earned for the year or the maximum Social Security base wage for that year. The annual income is indexed to reflect the rise in average wages each year. Indexing levels the value of earnings from earlier in your career so they are comparable to those earned later. For example, $10,000 earned in 1983 may be worth the purchasing power of $40,000 in 2018 dollars. Earnings through age 60 are indexed, and post-60 wages are not indexed. Post-60 earnings do count in the calculation; they just are not indexed. The Social Security Administration selects and sums the 35 highest inflation-adjusted yearly earnings. The sum is divided by 420 (35 years times 12 months per year). The result is the AIME, which is used to calculate the Primary Insurance Amount (PIA). The PIA is the monthly benefit that a worker will receive at Full Retirement Age (FRA). The benefit formula is progressive (low earners receive a greater proportion of the pre-retirement income) with three tiers. The first $895 of AIME is multiplied by 90%, the next chunk up to $5,397 is at 32%, and the amount over $5,397 up to the annual maximum is multiplied by 15%. For 2018 the maximum PIA is $2,788. The bend points in the formula are adjusted each year based upon the growth in the economy-wide average earnings.

For example, three friends, Abe, Bob, and Clay were all born in the 1956 and their respective AIMEs were $2,800, $5,600, and $11,200. The PIA for Abe would be $1,415 [$895 times 90% + ($2,800 – 895) times 32%]. His PIA is 50.5% of his AIME. The PIA for Bob is $2,277 [$895 times 90% + ($5,397 – $895) times 32% + ($5,600 – $5,397) times 15%]. Bob’s PIA is 40.7% of his AIME. Bob’s AIME is 100% higher than Abe’s AIME and his PIA is only 60.9% higher. Clay’s PIA is limited to $2,788, the 2018 maximum benefit at age 66. Clay’s PIA is 27.3% of his AIME. Clay’s AIME is twice that of Bob yet his PIA is only 22.5% higher. The example illustrates the progressive nature of Social Security benefits. Recipients with lower AIMEs collect a higher percentage of benefits. However, workers with higher earnings generally collect higher benefits. The bend points used for the benefits computation are those in effect at your age 62.

If you are age 55 and doing retirement planning, what do you do?  First, you need to review the accuracy of your earnings record. Second you need to make realistic assumptions regarding your future earnings. The index factors for earning from now until age 60 along with the bend points at your age 62 require estimation. If you use the projections provided by the SSA using their website, remember estimates have been employed. Also, the retirement benefits reported on the SSA statement for age 62, FRA and age 70 are in today’s dollars. If you are currently age 55, your benefits at FRA will most likely be higher due to cost of living adjustments.

As reported in the last article, FRA for those individuals born in 1937 and prior was 65 and gradually increased to 66 for those born in 1943. For those individuals born after 1954 the FRA creeps up year by year in 2 month intervals until those born in 1960 have a FRA of 67. The early retirement penalty also increases as the FRA lengthens. The early retirement penalty decreases to 0% gradually (but not linearly) as the recipient’s age gets closer to full retirement age.

Average Monthly Benefits

The average monthly benefit for retired workers in 2018 is $1,404. This appears to be quite low in comparison to average earnings of $45,000+. The primary reason for the low average is the vast majority of workers start to collect Social Security at age 62 or 63. Retiring in 2018 before FRA means realizing an early retirement penalty of 25% if retired at 62 or 20% if retired at age 63.


Reviewing your earnings statement can be informative. Spouses who have flexibility to legitimately allocate their income, such as couples in their own business, can use the progressive nature of bend points in the PIA formula to maximize the benefits for the couple. Obtaining a good estimate of your benefits is critical. Some online calculators are easy to use, others can be very time-consuming, and some require a fee. The calculators can generate varying results. Understanding the formula should help you evaluate the results. Your SSA statement is the most authoritative source and easiest to obtain. The SSA says that it provides information and not advice. Regardless of the source for your benefits estimate, you need to confirm that the historical earnings are correct and future earnings estimates are realistic. Is the estimate quoted in today’s or future dollars?  Are the payments gross or net of withholding for taxes and Medicare Part B? Planning for a safe and secure retirement is important. You may want to consult with an adviser who is experienced on the topic.

View the first article in this series here. The third article in the series can be found here.

By Francis C. Thomas, CPA/PFS

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