What is it?
Social Security is a social program that provides a significant portion of income for those in retirement. The technical name for it is the Old Age, Survivors and Disability Insurance system (OASDI). You have likely paid into the system most of your adult life. If you look at your pay stub and see the word ‘FICA’ on there, know that 6.2% of your income goes toward funding Social Security. The employer pays this same amount for you too. If you’re self-employed you now pay 12.4%, essentially paying as both the employee and employer. If you earn over $118,500 (in 2016) you no longer have to pay Social Security tax on earnings above and beyond this.
How Much Income Will I Get?
Primary Insurance Amount (PIA)
Every Social Security income calculation is based on your PIA. So, it’s important to understand what your PIA is and get a general idea of how it’s calculated. First of all, it’s based on your top 35 years of earnings. If you have less than 35 years where you paid into Social Security, then you have some zeroes factored in to your PIA formula. Also, any amount you earned in years before you were 60 years old are adjusted higher for inflation. So any amounts you continue to earn age 60 and older will not be adjusted for inflation. As mentioned earlier, as you earn over the maximum taxable amount each year you no longer have to pay Social Security tax; but earning over this limit will also cap the amount calculated toward your PIA for that year too. You would have essentially “maxed out” your contributions that year.
To calculate your PIA you need to first calculate your Annual Indexed Monthly Earnings (AIME). To do this, you adjust all your years of earnings before age 60 for inflation. Then take the top 35 years, remembering to cap any particular year’s income at the maximum taxable amount. Total up these 35 years, and then divide by the total number of months in 35 years which happens to be 420. This is your AIME.
In order to calculate your PIA from your AIME (stay with me here just a little longer), you multiply 0.9 times the first $856 of your AIME, 0.32 times $857 thru $5,157 of your AIME, a 0.15 times any amount over $5,157. Add these 3 amounts together, and that’s how you calculate your PIA! By the way, the numbers ‘$856’ and ‘$5,157’ are called bend points, and they increase over time due to inflation.
So you’re now ready to figure out your exact income every year of your working life, adjust it for inflation, do some basic math, and then a bit more algebra and calculate your own PIA, right? Well, if you want to, by all means. But the Social Security Administration (SSA) keeps track of all these numbers for you, and will simply tell you what your PIA is if you ask. You can also create an account at https://www.ssa.gov/myaccount/ to see what your PIA is anytime you like.
So now that we know what our PIA is, we can figure out what our Social Security income will be based on when we start collecting it. So, you are entitled to 100% of your PIA at your full retirement age (FRA). The following is a chart that shows you what your FRA is depending on the year you were born:
Calculating your monthly benefit
The most common type of Social Security income is based purely off of your own earnings history. This is called a worker’s benefit. You can begin claiming this income anytime between ages 62 and 70. If you begin collecting before your FRA, you will get less than 100% of your PIA each month. In order to calculate how much you will receive, count the number of months before your FRA when you started receiving benefits. If you started collecting within 36 months of your FRA, multiply this number times 5/9th of 1%. Then subtract this percentage from 100%. This is the percentage of your PIA you will receive. If you started collecting more than 36 months before your FRA, multiply 5/9th of 1% times 36 months (this equals 20%); then count the number of months past 36, and multiply time 5/12th of 1%. Add these two together, and then subtract from 100%.
It always helps to give examples:
- Joe starts collecting his Social Security income at age 63. His FRA is age 66 because he was born in 1950. He will receive 80% of his PIA: [100% - (5/9 x 1% x 36) = 80%]
- Nancy will start collecting her Social Security income at age 65. Her FRA is age 66 and 6 months because she was born in 1957. She will receive 90% of her PIA: [100% - (5/9 x 1% x 18) = 90%]
- Bill starts collecting his Social Security income at age 62. His FRA is age 66 because he was born in 1947. He will receive 75% of his PIA: [100% - (5/9 x 1% x 36) - (5/12 x 1% x 12) = 75%]
So if you take a reduction in income if you start withdrawing before your FRA, wouldn’t it make sense if you get more than your PIA if you wait until after your FRA to start? I think so, and so does the SSA. To calculate your benefit by waiting, first count the number of months after your FRA when you started receiving benefits. Multiply this number by 2/3rd of 1%. Then add this number to 100%. This is the percentage of PIA you will receive. A quick example: Linda waits all the way until 70 to start collecting her worker benefit. Her FRA is 66 because she was born in 1944. She will receive 132% of her PIA: [100% + (2/3 x 1% x 48) = 132%.
A couple quick observations to note about what we’ve covered so far:
- Your Social Security income grows by 8% for each year you wait past your FRA
- Your income if you wait til 70 is about 76% higher than it would have been if you claimed at 62
Can I Claim Off of Anyone Else’s Record?
I’ve just illustrated how to calculate your benefits based on your record. But you can also claim based off the record of a spouse, ex-spouse, or deceased spouse. An important point to remember is that claiming benefits off of someone else’s record will not affect their benefits at all.
There are 2 ways to claim benefits based on your spouse’s record:
- If your PIA is less than half of your spouse’s PIA, you will get an increase in your income only if both of you have filed for benefits. For example, if your PIA is $600 and your spouse’s PIA is $2,000, and you sign up to start drawing benefits at your FRA, you will only receive $600 if your spouse has not filed yet. If he or she filed, you would be entitled to $1,000.
The most you can get off of a spouse’s record, then, is 50% of their PIA. And just like drawing your worker benefit early causes you to get less than 100% of your PIA, the same is true where if you claim spousal benefits early you will take a reduction for every month before FRA you start drawing. This formula gets a bit more complicated than that for a worker’s benefit so just understand the concept of having a lower benefit the earlier you start drawing.
- The second way to claim spousal benefits is to use a filing strategy called “filing a restricted application for spousal benefits only”. You are only eligible for this strategy once you reach your FRA. If you start drawing any Social Security benefits before your FRA, you can’t file for spousal benefits only. Also, based on a new law passed in late 2015, this strategy is now restricted to folks born before January 2nd, 1954. Anyone born this date and after can’t use it.
The way it works is that if you wait til FRA, you can draw a benefit based only off of your spouse’s record. When you claim spousal benefits before FRA, you technically are receiving a benefit based on both your and your spouse’s record. So you are really receiving your worker’s benefit with a spousal addition. By waiting until your FRA, you receive 50% of your spouse’s PIA only. Also, it doesn’t matter how big your or your spouse’s PIA is, you can still use it. By filing for spousal only, this will allow your worker benefit to continue to grow at 8% per month as explained earlier.
The rules for claiming benefits of off your ex’s record are very similar to claiming off a spouse’s. However, there are some extra conditions you have to meet in order to use this strategy:
- You must currently be single
- You have to be divorced for at least two years
- Your marriage must have lasted for at least ten years
- Your ex must be eligible for their own benefits, but they are not required to be collecting already
You can still collect in the same two ways as spousal benefits. The same qualifications and reduction formulas apply. And one last thing to mention is that if you decide to claim benefits off of your ex’s record, he or she will never be notified! You don’t have to ask for permission or be worried about him or her trying to deny your claim.
You can claim off the record of your late spouse. Also, if your ex passes away, your benefits can then switch from ex-spousal benefits to widow’s benefits. The earliest you can start collecting widow’s benefits is age 60, unlike age 62 from a spouse or ex-spouse. You can actually start collecting as early as 50 if you are disabled, or even at any age if you are caring for the deceased’s child who is either younger than 16 or disabled.
Just like any other Social Security benefit, you will take a reduction if you start receiving them before your FRA. But two things are different with widow’s benefits: the FRA, and the benefits reduction formula. The FRA uses the same age brackets as the worker and spousal FRA age brackets, but the birth years corresponding to these brackets are shifted by 2 years. Huh? Ok, consider someone born in 1955. Their FRA when calculating their worker or spousal benefits is age 66 years and 2 months. However, their FRA when it comes to considering widow’s benefits is age 66. It’s much easier to see in the chart below as a comparison:
Once you know your widow’s FRA, now you can know how much your benefit could be reduced if you take it before your FRA. The reduction formula here is not a specific percentage amount of reduction for each month you claim early. Instead, first the largest your benefit reduction can be is 28.5%. So the way to calculate your reduction is first to count the maximum number of months early that you could have started your benefit. Divide 28.5% by this number. Then multiply the result by the number of months you did take your benefit early. Then, subtract this percentage from 100%, and that’s your reduction in benefits percentage. So for example, if your FRA is age 66 and you start drawing widow’s benefits at 61, your reduced widow’s benefit is 76.25%. [100% - (28.5%/72) x 60] = 76.25%.
But 76.25% of what? Ahh, this is where it gets tricky. And I know what you’re thinking, “you mean this isn’t tricky enough yet?” When figuring out what amount you can collect as a widow, this reduction percentage matters, but so does whether your late spouse started claiming their Social Security before they passed, when they started, and what their PIA was. Because the calculations now involve several different possible scenarios based on these several factors, I’m not going to go any deeper into calculating the exact amount. The general rule of thumb though is that the surviving spouse keeps the larger of the two Social Security incomes (with some exceptions, of course). So as long as someone’s widow’s benefit is larger than their worker’s benefit, their monthly Social Security amount then becomes the amount of the widow’s benefit.
Will my Social Security Ever Increase?
Yes, the first reason it will increase is due to an annual cost-of-living adjustment (COLA). However, in some years COLA will be 0%. COLA is based on the annual increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). If there is not an increase in the CPI-W though, there will never be a negative COLA, meaning your Social Security income will never decrease. And since all Social Security benefit calculations are based on your PIA amount, the COLA is directly applied to the PIA. The reason this matters is that you don’t miss out on these COLAs if you are waiting to start your benefits because the percentage of benefits that you get (either by waiting or starting early) is always based on the percentage of your PIA.
You could also claim several different types of benefits over the course of your life. You could start by claiming your own worker's benefit, increase it to a spousal benefit after your spouse starts claiming, and then switch to a widow’s benefit if your spouse passes away first if the widow’s benefit is greater than your spousal benefit. This is just one of many possible scenarios.
When Should I Sign Up, and What Type of Benefit Do I Take First?
The golden rule that I live by when advising clients in selecting a Social Security claiming strategy is “collect the largest benefit for the longest period of time”. All the analysis boils down to maximizing the amount of lifetime Social Security income you can get.
As you can see in the rest of this article, the Social Security system is incredibly complex. It makes it a little easier that you don’t have to do all the calculations yourself; Social Security will tell you how much your PIA is, how much you will get if you collect off of an ex-spouse, etc. But, what they won’t tell you is when you should start drawing and advise you on which benefit to draw first. They tell you what you can do, not what you should do. That constitutes advice and they are not legally allowed to advise you.
In this low interest rate environment, making the right Social Security claiming decision is the most important decision you can make concerning retirement income planning. Almost all other decisions pale in comparison to deciding what Social Security benefit to draw and when. The difference between claiming early vs. claiming later can result in a six-figure difference of lifetime income between the two strategies.
Social Security is your financial cornerstone in retirement. It’s important to get the advice of an expert in planning how your Social Security income fits in to your retirement income picture as a whole. If you realize you may not be sure on what to do here, or even if you’ve made your claiming decision but would like a second opinion, just contact me and leave your contact info and I’ll be in touch soon to schedule a retirement income planning consultation.