A Social Security primer: How Social Security is calculated

By Marc I. Lebow, CPA, Ph.D., and Joseph E. Lebow, O.D.

We accountants, as financial advisors to our clients, are likely to ask us: When is the best time to start collecting Social Security retirement benefits? This issue is complex; every person’s situation is unique. The best decision for one person may not be correct for another in a different situation. But, being deeply aware of our client’s financial situation, accountants are uniquely qualified to provide objective and knowledgeable advice.

In this three-part series on Social Security, we’re sharing a framework we use to guide our clients’ decision process. 

First, there is the question about whether to view Social Security retirement benefits as an investment or as an insurance policy. Many people looking toward retirement will view retirement benefits decisions as an investment: “I want to get the most that I can get in benefits.” Others may regard Social Security as insurance to minimize against financial risk during retirement: “I want to be okay financially if I live to be 100.” We generally tailor our advice to the client’s position.

One factor that must be addressed before anything else: Social Security benefits are a “fund as you go” system. This means that the monies contributed by current workers are immediately disbursed to current retirees; there is no pool of funds waiting for the retired to collect.

As the Baby Boomer generation has aged and swelled retirement rolls, and the number of current workers contributing to the fund has not risen as fast, there is an imminent problem that the fund may go bankrupt. Although we recognize the problem, this article will not offer solutions to Social Security solvency; we can only present the latest facts.

First, it is important to understand how Social Security benefits are calculated and funded.

Calculating Social Security benefits

Taxpayers contribute money into the Social Security retirement system and expect to then collect money from the system. If one considers the contributions into the system as investments and payments from the system as a return on the investments, then a return on that investment can be calculated. 

From its inception, Social Security was structured to help those with lower incomes have greater supplemental retirement income. Although the program provides a higher benefit to those who contribute more, the system is designed to generate a higher return for those with lower contributions. This is reflected in the benefit formula shown below.

Using the formula, calculating the benefit requires several steps. The first step is to record and then index the beneficiary’s annual earnings. Every year, the Social Security Administration publishes an index to standardize past earnings to current purchasing power which has been depreciated by inflation. As inflation devaluates the purchasing power of the dollar, the index standardizes earnings such that wages earned in the past can be better compared to current earnings. We used the index and formula for 2022 in the pro-forma calculations discussed below. 

The annual earnings for past years are multiplied by the index and then sorted so that the highest 35 years of indexed earnings are identified. An average of these top 35 years of indexed earnings is calculated and divided by 12 to determine the Average Indexed Monthly Earnings (AIME). The AIME is then applied to a formula based on the year.

Assuming the person retires in 2022, the formula is applied to the AIME as follows:

• 90% of the first $1,024, plus
• 32% of the next $5,148, plus
• 15% of any amount over $6,172.

The sum of the above formulary is the Primary Insurance Amount (PIA) — or the amount the recipient will receive each month in retirement benefits at their full retirement date as set by the Social Security system. Social Security applies an adjustment factor if someone retires before or after their designated full retirement date. If a worker delays retirement, the PIA increases by 8% for every full year retirement is delayed until age 70, when the recipient must take their maximum earned benefit. If the person retires earlier than the full retirement date, the PIA is adjusted down and  the retiree loses 5–6% for each year they retire early. 

Additionally, the lower the AIME number, the higher the PIA as a percentage of the AIME. In other words, if one’s AIME is $1,024 then the PIA is 90% of the AIME. The higher the AIME is over $1,024, the lower the internal rate of return (IRR) of the payments.  

Calculating Social Security contributions 

Only earned income below a set cap is taxed for Social Security retirement benefits. This is income earned by our labors: salaries and wages. Basically, 6.2% of earned income is deducted from one’s gross earnings and sent to the Social Security Administration to fund one’s retirement benefits. There is an upper limit at which time earnings are no longer subject to Social Security retirement taxes. The amount is adjusted for inflation and was $147,000 in 2022, $160,200 in 2023, and $168,200 in 2024. Passive income like rents and interest are not subject to the Social Security tax.

In addition to the taxpayers’ contributions, the employer must match the amounts deducted from the employee’s paycheck as a payroll tax into Social Security. From an economic perspective, this means the contribution is really 12.4% (6.2% x 2); economists would argue that one’s earnings are really the cost to the employer to employ the individual. Benefits like health care, retirement, and vacation pay are costs to employ the worker and thus earnings to the worker. For this analysis, we will ignore this fact, although those whose earned income comes from being a sole proprietor or partner in a partnership should halve the IRR calculated in the next installment because they pay both the employee and employer’s tax.

Other benefits earned through Social Security 

The Social Security retirement fund subsidizes two other major benefits for those who qualify. First, if the worker becomes disabled, they may qualify for Social Security disability benefits. Social Security also offers survivor benefits; a dependent spouse and/or a dependent children may qualify. Although these could be significant financial benefits, we will not include them in our analysis.

A note on Medicare, which is different from Social Security retirement benefits. Medicare provides subsidized health insurance to workers over 65. Workers contribute 1.45% of all earned income into the Medicare trust fund; there is no upper limit to Medicare contributions.

The next article will dive into the IRR of Social Security benefits based on different income levels, retirement ages, and ages at death. Knowing those factors should help workers tailor their retirement ages based on their individual goals.

Marc Lebow, CPA, Ph.D., has been a teacher in the Hampton University Accounting Department since 1995. Before earning his Ph.D., Marc worked in public accounting for three years and for the Virginia Auditor of Public Accounts for three years.

Joseph E. Lebow, O.D., is president of Lebow Eye Associates, PC, and practices optometry with offices in Hopewell and Chesterfield. He graduated from the Southern College of Optometry in Memphis after attending Virgnia Tech. Turning 62 this year and becoming eligible for Social Security benefits puts him in the middle of this complex decision-making process.