This is How Social Security Benefits are Calculated - Part 1
Many people have a misperception about how their Social Security benefits are calculated. Some people think that their benefit is calculated by using their last 5 years of earnings. Others believe that if they retire from their full-time job and then work part-time for a number of years, those much lower part-time earnings will decrease their Social Security benefit. There are many other misperceptions about how Social Security calculates benefits.
Social Security Benefits Calculated Using 35 Wage-Earning Years
When Social Security calculates your benefit, they have a formula that uses your highest 35 wage-earning years. Even if you worked for 40 or even 50 years, they will still only use your highest 35 wage-earning years. If you worked less than 35 years, they still use 35 years in their calculation. And for any years less than 35 that you worked, they will include $0s in their formula. If you had 25 years of work history, they would use those, but will also include ten years of $0. Those ten years of $0 will decrease your benefit. If you continue to work and replace those $0 years with actual earnings, that will increase your benefit.
Social Security Uses a Weight Factor to Calculate Benefit Amount
Another misperception is that if you work in your 60s, your earnings will be much higher than 35 years ago. Social Security will replace those much lower earnings from years ago with the much higher amount you are making in your 60s. That would be a logical assumption to make, but that may not be the case.
It turns out that Social Security uses a weight factor that can significantly increase your earnings from the past. That weight factor can increase your earnings from years ago. Sometimes, even making them so large, they exceed earnings from your most recent years.
For example, if someone turns age 62 in 2023 and last year they had earnings from their job of $87,000. Let’s assume they have 35 years of work history. Going back 35 years will bring us to the year 1988. In 1988, they only earned $30,000 from their job. This person usually receives an annual pay raise of about 3%. If they work another year, that 3% raise would increase their current earnings to $89,610 ($87,000 x 1.03). It would be logical to assume if they work another year, in Social Security’s formula to determine their benefit amount, they will replace the $30,000 in earnings from 1988 with their current earnings of $89,610, and that should increase their benefit. But in this case that would not happen.
A Closer Look at the Formula
It turns out not to be the case. The weight factor that Social Security will apply to their 1988 earnings is 3.13. Social Security will multiply their 1988 earnings of $30,000 by 3.13, which will increase their 1988 earnings to $93,900 ($30,000 x 3.13). Their 1988 weighted earnings of $93,900 are greater than their current earnings of $89,610. In their benefit calculation formula, Social Security will keep their weighted 1988 earnings of $93,900 and not add their current earnings of $89,610.
Of course, if their current earnings were much higher at $125,000, Social Security would drop or delete their weighted 1988 earnings of $93,900 and add their current earnings of $125,000 and that would slightly increase their benefit. I say slightly increase because they are only replacing 1 out of 35 years of work history and that difference is only $31,100 ($125,000 – $93,900).
As I said before, if you don’t have 35 years of work history, Social Security uses $0 in its calculation for all the years less than 35 in which you did not work. If you continue to work and replace those $0 years with actual earnings, that will result in a more significant increase in your benefit.
Social Security applies a weight factor to all of your earnings you made prior to your 60th birthday. No weight factor is applied to any of your earnings made after age 60.
Now you know how your Social Security benefits are calculated, but this is only Part 1. Keep a look-out for my next article on How Social Security Benefits Are Calculated, Part 2. In that article, I address another common misperception about how Social Security benefits are calculated.
