Understand How Social Security Calculates Your Benefits

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More than 59 million Americans will receive Social Security benefits this year totaling almost $863 billion, according to the Social Security Administration. More than half of all married couples and almost three-quarters of all unmarried retirees rely on Social Security benefits for at least 50 percent of their total household income.

Still, as important as that income is for so many retirees, many Americans don't understand how those benefits are calculated. And what you don't know about how your benefits are calculated can hurt you. In particular, the decision to take a higher-paying job or work an extra year before retiring won't pad your Social Security check as much as you'd expect. That's because the formula the SSA uses doesn't treat every dollar of income in your work history the same.

The Progressive Nature of Social Security

Social Security benefits are based on average indexed monthly earnings. Rather than simply taking your average salary over time, AIME takes into account inflation. As a result of this indexing, earnings early in your work history have a larger impact on your Social Security benefit than they otherwise would.

For example, workers who retire this year at age 66 would have their wages from 1981 multiplied roughly by three to be comparable to wages they earned over the past few years. The SSA then adds up the indexed earnings from your 35 highest-paid years and takes the average monthly amount.

Indexing for wage inflation treats workers equally. But once the SSA calculates your AIME, the next step of the calculation is where differences appear in how much workers at various income levels receive in benefits.

To figure your monthly payment, the SSA needs to determine what it calls the primary insurance amount, and it uses a formula that translates your AIME and into the PIA. That formula uses different percentages based on how large your AIME was, with those percentages changing at certain breakpoints.

Low Wage or High?

Specifically, using 2014 figures, retirees get 90 percent of the first $816 of their average indexed monthly earnings. In other words, low-wage part-time workers making less than about $10,000 per year have almost all of their pre-retirement income replaced by Social Security -- assuming you retire at your normal retirement age.

But those who earn higher amounts get much smaller percentages of their AIME reflected in their benefits. For the amounts between $816 and $4,917, Social Security adds in only 32 percent to determine your primary insurance amount. Above $4,917, only 15 percent is included in your benefits. So for someone who made around $30,000 per year adjusted for inflation throughout their career, the primary insurance amount is about half of average earnings. For a $100,000 earner, that figure falls to around 30 percent.

Being progressive is an inherent part of Social Security. One goal of Social Security is to provide for adequate levels of income for retirees regardless of how much in taxes they paid into the system, and so some level of inequality is consistent with that goal. Yet at the same time, the SSA also notes the need for equity in having benefits somewhat reflect the amount that each person contributes through Social Security taxes throughout their careers.

Why You Should Care About These Progressive Benefits

Social Security's progressive nature has implications for workers, especially those who've had careers shorter than 35 years. The AIME calculation treats someone who has earned $40,000 for 15 years the same as someone earning $20,000 for 30 years. Working an extra year will have a bigger impact on the 35-year average earnings for the person with the higher earnings and the shorter career, boosting benefits. If you're still in the lowest range of the benefits calculation, then working longer has a large positive impact on your monthly payments. But as average earnings rise above the breakpoints, the amount of extra benefits drops -- giving you diminishing returns that provide less incentive to work longer.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google+. In our new free report, Motley Fool retirement experts give their insight on a simple strategy to take advantage of a little-known IRS rule that can help ensure a more comfortable retirement for you and your family.
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