How are Social Security Benefits Calculated?

You are nearing retirement age and wonder how much money you can expect from the federal government in Social Security benefits each month after leaving the workforce.

The short answer? The amount of money you earn while working determines your monthly benefits. Of course, it is not entirely that simple. The Social Security Administration also factors inflation and other formulas to determine your final monthly benefit.

The length of your working career and how early you retire will also impact your monthly benefits.

Here's a closer look at what goes into determining the amount of money you will receive each month:

Your Income

When determining your monthly benefits, the Social Security Administration considers your 35 best working years -- the years in which you earned the most income.

It is important to note that the Social Security Administration might not use all of your earned income during these years when calculating your monthly benefit if you are a high-wage-earner. In 2022, for instance, every dollar that you earn above $147,000 will not count for Social Security benefits purposes.

You will also face income limits if you take Social Security benefits and continue to work between the ages of 62 and your full retirement age. Full retirement age is somewhere between the ages of 65 and 67, depending on your birth year. In addition, if you have not yet reached your full retirement age and earn more than $19,560 a year in 2022, then $1 will be deducted from your benefits for every $2 earned over $19,560.

The Calculations

The Social Security Administration takes the average of your 35 highest-earning years to determine your monthly benefit. That figure adjusts for changes to average worker wages since the period in which you earned your money.

That is known as adjusting or indexing workers' earnings. This step makes sure that your future benefits reflect the rise in the standard of living that occurred during your years of working.

The Social Security system is also progressive in that lower-wage earners receive a higher percentage benefit than higher-wage earners do. This is because the system returns a higher percentage of pre-retirement earnings to a lower-wage worker than a higher-wage worker.

The Social Security Administration uses all this information to create your AIME or averaged indexed monthly earnings. Eventually, the Social Security Administration calculates your Primary Insurance Amount or PIA. That is what you will receive each month from Social Security.

Retirement Age

However, the retirement age significantly impacts the amount of Social Security benefits you receive each month. So, if you retire too early, you will earn less each month in benefits.

As of 2018, the earliest age to begin collecting Social Security benefits is 62. However, if you start receiving your benefits at this age, you will receive reduced monthly benefits. There's a reason for this: The federal government figures that you will be collecting your monthly benefits for a longer time if you retire at age 62. So monthly benefits are reduced for early retirees to make sure your payments equal out over your lifetime.

How much of a reduction will you face by retiring early? According to the Social Security Administration's website, primary wage earners can expect to receive just 70 percent of their total monthly benefits if they retire at age 62 instead of 66 or 67. In addition, the spouses of primary wage earners will take an even more significant hit; they can expect to earn just 65 percent of their total monthly benefits if they retire at the age of 62.

The message seems clear: It makes more financial sense to begin collecting Social Security payments at or after full retirement. But, of course, even this matter is more complicated than it seems. For instance, if your health is poor, you might not live a long life after retiring. So collecting benefits early on might make sense. Also, if you are out of work and can't find a new job, it might make more sense to collect benefits earlier rather than later.

As you near retirement age, be sure to check for the Social Security benefits statements that the government has sent you since you turned 25. These reports list the amount of income you have declared each year and provide an estimate of how much Social Security money you can expect to earn each month, depending on the day you retire.