For 2018, the maximum social security benefit is $3,698 per month or $44,376 per year. In contrast, the average benefit currently paid out is only $1,362 per month or $16,344 per year. The three most important factors that determine a worker’s social security benefit in retirement are their earnings history, the numbers of years they worked, and the age at which they choose to begin benefits.
How Your Benefit is Determined
One of the Social Security Administration’s responsibilities is to record each worker’s lifelong earnings as reported by their employer. To compute a worker’s benefit, they first look at a worker’s lifetime average earnings as determined by the highest 35 years of earnings, adjusted for inflation up to age 60. Earnings after age 60 are not indexed for inflation. If the worker has not accumulated the full 35 years of earnings, any year below 35 will show up as a zero thereby reducing their lifetime average.
Not surprising, the more you make, the more you pay into social security in the form of payroll tax. On your W-2, you will see the letters FICA which stands for Federal Insurance Contributions Act. This payroll tax in its current form is equivalent to 15.3% of your wages. Employers and employees pay 6.2% each for old-age, survivors, and disability insurance and another 2.9% each for hospital insurance. FICA is applied to earned income up to what is known as the taxable maximum. In 2018, the taxable maximum is $128,400. Next year, it will be $132,900. Only 6% of covered workers have earnings above the taxable maximum in any given year. The taxable maximum income increases most years. Also, for high earners, the Patient Protection and Affordable Care Act (more commonly referred to as ObamaCare) created an additional Medicare tax of 0.9% and is entirely paid by high earners - meaning employers do not pay half of this tax like they do the others.
The age that you begin to take your social security benefit is another important factor in determining how much your benefit will be in retirement. Today’s maximum monthly benefit is $3,698 but this is only for eligible workers that wait until they are 70 years old to start their benefits. In the past, retirees would turn age 62 and simply “turn on the spigot” to begin their social security retirement benefits. In fact, more than half of current social security recipients started their benefits at age 62.
Workers today are increasingly aware of the importance of making an informed decision about when to initiate their social security benefit. Let’s look at the numbers. The maximum for someone who is 62 in 2018 is $2,158 per month. Instead of $44,376 per year, a 62-year-old receiving the maximum social security benefit today is only getting $25,896 per year. This is an $18,480 per year difference. Assuming a 2.5% annual cost of living adjustment, this is a difference of $472,065 over a period of twenty years or $811,321 over thirty years. For some retirees, the age they start taking social security can be a million dollar decision, especially if you take spousal benefits into consideration.
Full retirement age (FRA) is when a worker can receive full retirement benefits. Taking social security before FRA results in a reduction in benefits and delaying until age 70 results in an increase in benefits. Everyone born after 1960 presently has a FRA of 67. Currently, the penalty for someone that files for social security before FRA, up to 36 months early, is a reduction 5/9 of 1% for each month filed before FRA. Their monthly benefit is reduced by 5/12 of 1% for each month filed early in excess of 36 months before FRA. Alternatively, if someone delays taking social security after her FRA, she will receive an increase of approximately 8% for each year she delays up until a maximum age of 70. The Social Security Administration refers to this increase as a delayed retirement credit. Postponing benefits effectively guarantees retirees an 8% annual average return - a rate that is hard to beat.
There are instances where starting benefits early is the right decision. A person may not have saved adequately for retirement, or they find themselves suddenly unemployed and must claim their social security benefits as a matter of survival. Others may be terminally ill or otherwise have a reduced life expectancy. In this case, it may make sense to claim benefits early in order to receive as many years of payments as possible. It should be noted that married retirees in this situation that opt for a lower payment may also impact the surviving spouse’s benefits. The examples I just gave are the exceptions and not the rule.
In order to receive the maximum benefit, you need to be 70 when you start drawing social security and you must have earned at least the taxable maximum for 35 years. This does not mean you have to wait until you are 70 years old to retire. With good planning you can retire early and delay taking your social security benefit until age 70. Whether you are managing your own retirement plan or working with a qualified professional, you want your plan to optimize your different sources of income and manage risks at the same time. By risks, I mean health risks, longevity risks, market risks, and inflation risks just to name a few common ones.
Studies show that most people that start their benefits early do not understand the ramifications of their decision. They know they can start taking at age 62 so that’s what they do. This lack of planning can make the difference of hundreds of thousands of dollars over one’s lifetime. It is very important that each person take time to educate themselves or work with a qualified professional that can provide the guidance they need in order to make the best decision for themself and their family.
Social security is one of the few sources of income that protects you against inflation risk, market risk, and longevity risk. When to claim your social security benefit is one of the most important but complex choices you'll face leading up to retirement. Make sure you understand the various strategies available to you. You should always seek personalized advice from a qualified professional before deciding when to take your social security benefit. In the meantime, create an account atto make sure your earnings are accurately reported and to track your estimated social security benefit. While you’re there, compare your earnings history with the annual that I have prepared for you going back to 1937. Finally, legislative changes will surely be coming to the social security program. It's important for you to understand the views of your prospective elected officials and to understand the changes that may impact you so you can plan accordingly.