Social Security Strategies: How Are My Benefits Calculated?

(MoneyWatch)  I've featured a few posts from Tiya Lim, my colleague at Buckingham Asset Management, regarding Social Security withdrawal strategies. She thought it would be helpful to explain how Social Security benefits are calculated, so here goes.

To qualify for benefits, you must work at least 10 years with annual earnings meeting a minimum amount. For 2009, you must earn $4,360 or more to qualify for a full year of Social Security earnings credit.

To calculate the monthly benefit available at full retirement age, the Social Security Administration adjusts every year of earnings for wage growth. The SSA essentially accounts for wage inflation by adjusting each year of earnings to a wage level you would earn when you're age 60. (An additional bonus is that earnings made after age 60 aren't adjusted downward.)

After adjusting each year for wage growth, the SSA uses the 35 highest years of earnings to calculate an average monthly earnings amount, which is called the Average Indexed Monthly Earning (AIME). If you have worked fewer than 35 years, the SSA will factor in annual earnings of $0 to complete the 35-year calculation. Once you hit 35 years of earnings, each year you work can replace a lower-earning year, which increases your AIME.

The final step is to apply a weighted average formula to the AIME. By doing this, the SSA makes the initial dollars you earned worth more. This benefits lower-income earners more as each additional dollar earned becomes less significant in the benefits calculation. In 2009, the first $744 of AIME gets a 90 percent weighting, while any dollars earned above the $744 level were weighted somewhere between 15 percent and 32 percent.

Here are two examples, with both people at full retirement age. John's AIME is $2,000, and Jane's is $6,000. Although Jane's AIME is 66.7 percent 200 percent higher than John's, her monthly benefit will not be 66.7 percent 200 percent higher than John's due to the weighting formula. In fact, her monthly benefit will only be 48.8 percent 95.4 percent higher than John's.

Monthly Benefit Calculations
		John		Jane
	SSA Weighting	Monthly Earnings of $2,000	Benefit Breakdown	Monthly Earnings of $6,000	Benefit Breakdown
Level 1: < $744	90%	$744	$669.60	$744	$669.60
Level 2: up to $4,483	32%	$1,256	$401.92	$3,739	$1,196.48
Level 3: >$4,483	15%	$0	$0	$1,517	$227.55
	Total Monthly Benefit for John		$1,071.52	Total Monthly Benefit for Jane	$2,093.63

Finally, no matter how much money you earn or the number of years you pay Social Security taxes, there's a cap on the monthly benefit. For 2009, the maximum benefit at full retirement age is $2,323 per month.

For further reading on Social Security, see the following posts:

• File and Suspend
• Double Dipping
• Former Spouses
• How Are My Benefits Calculated?
• Single Filers
• Understanding the Spousal Benefit
• Government Pensions: Offset Provision and Windfall Elimination Provision
• The Issues with Taking Benefits Early and Investing Them