In part two of our summary of the Social Security program, we’ll discuss the qualification requirements for retirement benefits, how they are calculated and adjusted, the point at which beneficiaries attain their full retirement age (FRA), and important rules for early or delayed filing. Our final segments will provide a summary of the types of benefits available, and some simple strategies that can help readers maximize their benefits.
Social Security benefits are paid to qualifying U.S. citizens and noncitizens that have a legal immigration status and otherwise meet all program eligibility requirements. Individuals admitted for permanent residency under the Immigration and Nationality Act and those that enter under the Family Unity or Immediate Relative provisions are common examples. A noncitizen may also receive benefits if they worked legally in the U.S., paid payroll taxes for a sufficient period of time to accrue benefits, and reside in a country where payments can be sent. Likewise, noncitizens that are married to a U.S. citizen residing abroad that meets the normal qualifications for a spouse or survivor benefit can receive their benefits if they reside in a country with which the U.S. has a Social Security Agreement.
Benefits are accrued by earning 40-lifetime credits that are based on paid work that is subject to Federal Insurance Contribution Act (FICA) tax. Social Security FICA taxes are assessed on the first $137,700 of wages (2020) at a rate of 12.4%. The tax is split evenly between an employer and their employee, with no further tax due on wages exceeding the prevailing wage limit. One credit of work is satisfied when earnings in a three-month calendar quarter exceed the minimum mandated level ($1,410 in 2020). These earnings, however, needn’t be spread out through the year, so the maximum 4 quarters of coverage for 2020 would be awarded if the worker’s first-quarter earnings were to exceed $5,6400 ($1,410 X 4). This noncumulative benefit accrual formula is favorable for those engaged in seasonal work and those who may leave the workforce for lengthy periods of time.
Although Social Security taxes are paid by some 96% of workers, there are two specific categories of workers that are exempt. As a result, they do not accrue Social Security benefits for their work.
1. Federal government employees hired prior to 1984 and covered under the Civil Service Retirement System (CSRS), which should not be confused with the Federal Employee Retirement System (FERS), whose members are covered.
2. U.S. railroad workers that are covered under the U.S. Railroad Retirement Act.
Those engaged in work that is not subject to Social Security payroll tax should also be mindful of the Government Pension Offset Provision and the Windfall Elimination Provision. The former reduces spouse or surviving spouse benefits for those collecting a pension based on work not subject to payroll taxes, while the latter affects those that have earned such a pension and have met the qualifications necessary to accrue Social Security benefits.
How benefits are calculated
Social Security benefits are highly progressive, providing a proportionately larger income replacement ratio for those with low average lifetime earnings. Benefits are calculated using only covered wages (i.e., those subject to FICA tax) and are averaged over a period of 35 years. Those with less than 35 years of earnings may see a material increase in their benefits through continued work, even if it’s part-time, as their current earnings replace zeros used in the benefit formula.
The formula includes the worker’s highest-earning 35 years and indexes those earnings to wage growth, until the year in which the worker turns age 60. The worker’s lifetime indexed wages are then divided first by 35 years and then again by 12 months. The result is the worker’s Average Indexed Monthly Earnings (AIME).
Next, the worker’s AIME is used to calculate their Primary Insurance Amount (PIA). The PIA represents the monthly benefit that the worker is entitled to when they attain full retirement age.
For 2020 benefit eligibility, the following formula applies:
- 90% of the first $960 of AIME, plus
- 32% of AIME from $961-$5,785, plus
- 15% of AIME above $5,785
Using the formula, a worker with an AIME of $2,000 would have a PIA of $1,196, while a worker with an AIME of $11,000 would have a PIA of $3,190. The progressive nature of the benefit formula is apparent, as a difference in average lifetime earnings of 450% results in a benefit that is only about 166% larger.
Full Retirement Age
Full Retirement Age (FRA) is the age at which a person is first eligible to receive benefits that are equal to their Primary Insurance Amount (PIA). The FRA convention applies to retirement benefits, spouse or ex-spouse, and survivor benefits that are based on a deceased worker’s earnings.
Social Security retirement benefits were first paid in January 1940 to workers age 65 and older. Retirement age remained constant at 65 until the 1983 Social Security Amendment gradually phased-in a 2-year increase. Citing improvements in health and increased longevity, the changes occur over a period of 22 years, with those born on or after January 2, 1960 subject to the full increase.
|Year of Birth||Full Retirement Age|
|1937 or earlier||Age 65|
|1938-1942||Increased by 2 months for each year|
|1955-1959||Increased by 2 months for each year|
|1960 and later||Age 67|
Retirement benefits may be claimed as early as age 62 at a reduction of 5/9 of 1% per month for claims filed within 36 months of reaching full retirement age, and 5/12 of 1% per month for each additional month. This formula also applies to spouse or ex-spouse benefits, but not survivor benefits which use a different benefit reduction formula. Moreover, benefits collected prior to FRA are subject to the Social Security earnings test, which temporarily reduces benefits paid to those under full retirement age with earned income exceeding the prevailing limit.
A reduction of $1 in benefits for every $2 of earnings in excess of $18,240 applies to those that will not reach their FRA at any point in 2020, while a reduction of $1 for every $3 of earnings above $48,600 applies to those that will reach their FRA sometime this year. The test no longer applies after the worker reaches their FRA. The amounts are adjusted each year and include only earned income. Pensions, annuities and portfolio income and capital gains are excluded.
Cost of Living Adjustment
The original Social Security Act of 1935 did not call for automatic benefit increases, leaving Congress with the role of establishing periodical increases through legislation. Since 1975 increases have been automatic, the result of an amendment of the original Act that occurred in 1972. The 1972 amendment provided for the last major expansion of benefits including automatic cost-of-living adjustments, an increase in the wage base and the annual earnings exemptions that apply to those collecting benefits prior to attaining full retirement age.
The Social Security COLA is effective each year on January 1st and is based on changes in the Consumer Price Index for urban wage earners, the CPI-W. The index is measured from the third quarter of the prior year to the third quarter of the year immediately preceding the change. The COLA formula provides an effective hedge against inflation, and rules related to Medicare Part B premium increases ensure that most recipients will never see their benefits reduced because of increased Medicare premiums. Combined, these provisions help to lift an estimated 15 million elderly Americans out of poverty.
Understanding the eligibility requirements and how benefits are calculated and adjusted is critical to making informed decisions about Social Security benefits. In our next segment, we’ll discuss the various benefit types and how to make the most of the benefits to which you may be entitled.
How well prepared are you for retirement? Contact us to find out.