As millions of baby boomers approach retirement the need for them to obtain a better understanding of their social security benefits and how to optimize them becomes increasingly important, if not critical. For most Americans, social security is their only pension plan and typically represents about 30-60% of their income in retirement.
So how are social security retirement benefits calculated? An individual's benefits are based on their highest 35 years of averaged indexed monthly earnings (AIME). You also need a minimum of 40 quarters (10 years) of earned income in order to qualify for any benefits. So, for example, if you have only 8 years of earned income and then stopped working in order to stay home with the kids, it may prove valuable to obtain 2 more years (8 quarters) of earned income as soon as possible. Even part-time work would suffice as you only need to earn $1,220 in a quarter for you to earn a qualifying quarter of social security earnings.
Please note however that if you, for example, had 10 years of earned income then social security would include a zero value for the remaining 25 years when calculating your highest 35 years of averaged indexed monthly earnings. Therefore, any opportunity you have to replace a zero income year with some earned income will result in an increase to your social security benefit.
In fact, if you have already started to receive social security benefits, but continue to work, each of those additional working years will also be eligible to be included in the calculation of your AIME. Therefore you have an opportunity to possibly increase your social security benefits even after you have started to take benefits!
The age at which you elect to take your benefits also has a significant impact on the benefits you receive. If you were born between 1943-1954, your "full retirement age (FRA)" would be age 66. If you chose to take your benefits at age 62 (your earliest eligible filing age) you would receive 25% less than your FRA benefit amount. If you instead elected to take benefits at ages 63, 64 or 65 you would receive 80%, 86.7% and 93.3% of your FRA benefit amount respectively. It's important to note, however, that these are permanent lifetime reductions in benefits when you decide to take your benefits early.
In contrast, if you delay in taking benefits, you can increase your benefits substantially. For each year after FRA, your benefits will increase by a guaranteed 8% per year plus any cost of living increases (COLA). Therefore, for example, if you defer taking your benefits until age 70 your benefits will increase by 32% guaranteed plus any COLA. This is a permanent increase in your lifetime benefits. Furthermore, all future COLA will be based on your now higher benefit base.
The impact of COLA should not be understated. For example, if your monthly benefit amount at FRA is say $2,000 and COLA averages 2.8% (the historical social security COLA) then your benefit amount will increase to $2,636 in 10 years, $$3,474 in 20 years and $4,580 in 30 years. On a cumulative basis this translates to total benefits of $304,246 in 10 years, $673,622 in 20 years and $1,160,479 in 30 years. It is also important to note that these totals represent values for one spouse only!
Clearly, there are a number of opportunities that individuals have to potentially increase their social security benefits. Understanding how your benefits are calculated and managing your earned income accordingly can help you to maximize your eligible benefits.
Ash Ahluwalia, NSSA, CCSCA, MBA