By Jim Blankenship

How much do you know about your Social Security benefit? For example, do you know the ins and outs of how your Social Security benefit is calculated? It's a pretty involved process, steeped in the history of the Social Security system. Calculating the Social Security benefit takes three steps:

    Calculating your average earnings over your lifetime; then

    Calculating your Primary Insurance Amount (PIA); and finally

    Calculating your actual Social Security benefit, based on your age when filing.

    Calculating your average earnings over your lifetime

    The first step is to calculate your average earnings over your lifetime. It's not as simple as just adding up your earnings and taking an average. There are limiting parameters to the calculation that must be factored in.

    To start, the earnings you've been credited with over your lifetime will only include those that you paid Social Security taxes on. If, for example, you had earnings that were not subject to Social Security taxation during your lifetime, those earnings will not be included in the calculation. One example of income that is not taxed for Social Security is certain state and local government earnings. Also, if you earned more than the applicable year's Social Security taxation limit, only your earnings up to the limit are included in your lifetime earnings for Social Security calculation.

    In 2019, the annual limit for Social Security taxation was $132,900. If you earned, for example, $140,000 from your job last year, only $132,900 is included in the calculation of your lifetime earnings for Social Security. The amount above that is neither taxed nor included in the lifetime earnings calculation.

    Now that we have that limitation covered, there is also the limitation that your income prior to age 22 is not included in the calculation. For most folks, this doesn't matter much. I mean, who earns significant money before age 22, anyway? I suppose it could be an issue for the likes some celebrities, but for most of us there's not much to be concerned about.

    So, we're counting Social Security-taxed earnings from age 22 up to the present, whatever age you might be. The problem with a simple list of earnings is that over time, inflation has caused your later earnings to be higher than comparable earlier earnings. To account for the general rise in the standard of living that occurred during your working lifetime, we multiply each earlier year by an indexing factor.

    The indexing factor is determined by starting with something called the Average Wage Index (AWI). This index is determined based on average wages across the nation. This information has been determined over the years by the Social Security Administration. (See the series of average wages with indexing factors here.) The difference from one year to the next is used for many Social Security calculations, including the wage base mentioned previously, as well as the annual earnings limit, quarters of coverage for each year, and bend points (which we'll address in the next section in calculating the primary insurance amount).

    When you reach age 62, your average indexed monthly earnings (AIME) is first calculated. Reporting lags cause issues with determining calculations, so Social Security uses your age 60 year as the base for calculations. The indexing factor for your income in your age 60 year (and each year thereafter) is 1.0 -- meaning, to determine your indexed earnings for that year, you multiply your earnings by 1.0 to determine the indexed earnings. For each year previous, the average wage for that year is divided by the average wage for your age 60 year to produce an indexing factor. The earnings for each year from your age 22 to 59 are multiplied by the resulting indexing factors to determine the indexed earnings amounts.

    For example, if you reached age 62 in 2018, your earnings from your age 22 to age 62 are indexed against the AWI series figure for your age 60 year. According to the AWI table, the figure for 2016 is $48,642.15. The figure for 2015 is $48,098.63. Therefore, your Social Security-covered earnings from 2015 are multiplied by the index factor of 1.0113. The same goes for each year throughout your lifetime when you had earnings. Take the AWI figure for that year, divide by your age 60 AWI figure, and then multiply your Social Security-covered earnings by the resulting index factor.

    Now that we have our list of indexed earnings, arrange them from the highest indexed figure to the lowest. Remember that any earnings after your age 60 are not indexed. From this list, select the top 35 years of earnings, and add together the top 35 indexed earnings amounts. Divide the sum by 420, which is the number of months in 35 years (35 x 12). The result is your average indexed monthly earnings, or AIME. The AIME is important for the next step in the process, calculating your primary insurance amount.

    Calculating your primary insurance amount

    Now that we've determined your AIME, we can begin with the process in the second step, calculating your primary insurance amount, or PIA.

    The PIA is the amount that your Social Security benefit would be if you filed for benefits to begin at exactly your full retirement age (FRA). At any other age, even a month before or a month after your full retirement age, your PIA is multiplied by an increasing or decreasing factor to determine your benefit amount.

    To calculate your PIA, we first need to know what bend points are applicable to you, based upon your age. Bend points are portions of your AIME, and the amount of each bend point is multiplied by a specific percentage to determine your PIA.

    Bend points are determined for each year, based on figures that were originally determined in 1977. The 1977 bend points were $180 and $1,085. These bend points have been indexed annually over the years, such that for 2018 the bend points are $895 and $5,397. For 2019, the bend points are $926 and $5,583. The bend points for your situation are always from the year you reach age 62.

    So, continuing our example from before, the person who turned 62 in 2018 will use the bend points for 2018 to calculate their PIA. Let's say this person's AIME (from step 1) calculates out to $4,000. The first $895 of his AIME is multiplied by 90%, giving a result of $805.50. The second part of the equation takes the AIME above $895 to the second bend point. Since his AIME is less than the second bend point, this means we use $4,000 minus $895 for the second bend point. $4,000 minus $895 equals $3,105 -- and this figure is multiplied by 32%, resulting in $993.60.

    If your AIME calculates to more than the second bend point, you would take any amount over the second bend point and multiply that amount by 15%.

    Then you take the three figures from your bend points and add them together. From our example, that means $805.50 + $993.60 + $0 = $1,799.10. This is the PIA for our example.

    For another example, suppose your AIME from the first step calculates to $7,000, and you reach age 62 in 2018. Applying the bend points as before, we have $895 times 90%, or $805.50 for the first bend point. The second bend point is $5,397 minus $895, or $4,502, times 32%, for $1,440.64 as the second bend point. Then the third bend point is determined by subtracting the second bend point from the AIME ($7,000 minus $5,397, or $1,603). This amount is multiplied by 15%, such that the third bend point figure is $240.45. These three bend point figures are added together, for a total of $2,648.95, rounded down to the nearest dime, so that the PIA is $2,648.90.

    Now that we have the primary insurance amount, we can move on to the last step, calculating your actual benefit.

    Calculating your actual Social Security benefit: With the PIA, we can calculate your actual Social Security benefit. The other factor, besides the PIA, is your age when you begin receiving Social Security benefits, relative to your full retirement age, or FRA.

    If you file for Social Security benefits to begin at exactly your FRA, your benefit will be the same as your PIA. For each month before your FRA, your Social Security benefit will be reduced from your PIA. Conversely, for each month after your FRA, up to age 70, your Social Security benefit will be increased from your PIA.

    The early filing reductions are relative to your FRA. For each month up to 36 months before your FRA, the PIA is reduced by 5/9 of 1%, or 0.556%. If you start benefits a full 36 months before FRA, the reduction amount is 20%.

    For each month greater than 36 months before FRA, the PIA is reduced by an additional 5/12 of 1%, or 0.417%. So for each full year (12 months) greater than 36 months before FRA when you file, the additional reduction is 5%.

    The delayed-filing increases are calculated as 2/3 of 1% for each month of delay in starting Social Security benefits after FRA. For each full year of delay, 8% is added to the PIA to calculate your Social Security benefit.

    Your FRA is determined by your year of birth. If you were born between 1946 and 1954, your FRA is age 66. For each year after 1954, 2 months are added to the FRA. For birth years of 1960 or later, the FRA is age 67.

    From our example, the individual was reaching age 62 in 2018 -- so this means her birth year was 1956. Therefore, her FRA is 66 years and 4 months.

    We determined the PIA for our first example was $1,799.10. As mentioned before, if she waits until she is at FRA (66 and four months) her Social Security benefit will be $1,799.10. But of course, many people begin Social Security benefits at other ages than FRA.

    Let's say she starts benefits at exactly age 62. This is 52 months before her FRA. Being more than 36 months before FRA, the first reduction is 20%. Then we take the months greater than 36 (52 minus 36 equals 16 months) times 5/12 of 1%, for an additional reduction amount of 6.67%. The total reduction for starting benefits at age 62 is therefore 26.67%. The resulting Social Security benefit is $1,319.30.

    Expanding further, if she waits until she's 64 to start benefits, the reduction would be calculated based on 28 months before FRA. Multiplying 28 months by the first reduction factor of 5/9 of 1%, we come up with a reduction of 15.56%. The resulting Social Security benefit in these circumstances is calculated as $1,519.20.

    On the other hand, if she delays filing to some point after FRA, her Social Security benefit is increased due to the delay. For example, if she waits until age 70 to begin receiving benefits (after age 70 no more delay credits are added), this is a total of 44 months of delay. Multiply this by 2/3 of 1% and we get 29.33% of increase for the delay. This results in a Social Security benefit of $2,326.80.

    About the author

    Jim Blankenship, a certified financial planner with Blankenship Financial Planning, a blogger, and author of A Social Security Owner's Manual and Social Security for the Suddenly Single: Social Security Retirement and Survivor Benefits for Divorcees.