Marginal Benefit
I'M A BIT EMBARRASSED to admit that, until I started toying with the idea of early retirement a few years ago, I was pretty ignorant about how Social Security worked. I didn’t even pay much attention to the FICA payroll taxes that were deducted from my paycheck.
As I looked into it some more, the prospect of receiving lifelong monthly checks from the government came as a pleasant surprise. I started researching how much I might get.
I learned that my retirement benefit depended primarily on two factors. First, the system would calculate a monthly benefit—called my primary insurance amount—based on my taxed Social Security earnings. The second factor would be when I decided to start benefits. I could claim Social Security as early as age 62, and take a permanent haircut on my benefits, or wait until as late as 70 to juice up my monthly payments.
Based on my birth year, the system designated 67 as my normal retirement age. That’s when I would get 100% of my primary insurance amount—the benefit I’d earned by paying Social Security taxes.
I was still unclear, though, exactly how my benefit would be calculated and whether early retirement might affect it. Should I plan to work longer to boost my monthly benefit? How much longer? Would my benefit grow substantially because of those extra years of toil?
I’d already paid the maximum Social Security payroll taxes for 15 years, thanks to the steady paychecks from my software engineering job. In my naïve thinking, if 15 years of payroll taxes got my primary insurance amount to, say, $1,500 a month, then each additional working year would proportionately increase the monthly amount by another $100 or so.
As with most things, the answer turned out to be more nuanced. To illustrate, imagine a hypothetical worker named Fred who was born in 1960 and started his career at age 22. Throughout his working years, he earned enough to contribute the maximum annual Social Security tax. The accompanying chart shows Fred’s monthly primary insurance amounts if he stopped working at different ages.
Notice that Fred gets nothing if he stops working before turning 32. That’s because it takes 10 years, or 40 quarters, of payroll tax contributions to be eligible for Social Security benefits. Also note the diminishing effect of Fred’s contributions on his benefits during the second half of his career. His benefit’s growth decelerates in his early 40s, and almost stops after age 57, even though he works five more years.
Why are Fred’s later contributions less valuable—or outright ineffective—compared to those earlier in his career? The devil is in the details of the timing and amounts of Fred’s Social Security contributions.
Fred’s annual contributions are indexed, or adjusted, to factor in wage growth over his working life. These indexed earnings are then combined over 35 years to calculate Fred’s average indexed monthly earnings. Think of this as Fred’s Social Security earnings averaged over 420 months, or 35 years of work.
What if Fred worked fewer than 35 years? His earnings would still be averaged over 35 years, but with zeroes for the idle years when no taxes were paid. And if Fred worked for, say, 40 years, his lowest-paid five years would be dropped from the equation.
This explains why Fred’s benefit barely budges after 57. If he keeps working, he’d be replacing lower-earning years with higher-earning years—but he’s credited with 35 years of work in either case. The difference between the two rates of pay isn’t significant enough to bump up his benefit much, particularly after the lower-earning years have been indexed for wage inflation.
Once Social Security computes Fred’s average indexed monthly earnings, it then plugs that number into a three bracket system to calculate his benefit payment. In the first bracket, each dollar of his credited monthly earnings adds 90 cents to his benefit, up to $1,115. The second bracket adds 32 cents for each dollar of credited earnings between $1,115 and $6,721. The third bracket adds 15 cents for each dollar of credited earnings over $6,721.
The idea behind these brackets is to favor the folks who’d probably need the benefits the most due to their lower lifetime income. For example, if Fred had a much lower-paying job, his benefits would be lower—but it would represent a much higher percentage of his working years’ wages.
In my case, starting my benefits at my full retirement age of 67 would provide me with 100% of the primary insurance amount to which I’m entitled. I’d receive a monthly payment for the rest of my life, which could be passed along to my wife if she survives me, plus it’s increased annually to keep up with the cost of living.
As sweet as all this sounds, 67 is not the age when I plan to claim. Waiting for my maximum benefit at age 70 seems like the wiser choice. My benefit would increase by 8% each year I delay claiming, plus annual cost-of-living adjustments will be added on top of that.
I won’t be working until I’m 70, though. Like Fred, working longer would increase my benefits only marginally—certainly not the $100-a-month boost that I’d imagined. Grinding beyond a few more years for the sake of a minimally higher Social Security payout doesn’t seem appetizing. Waiting a little longer to claim, though, does seem palatable given the big gain in benefits that would result.
Want to know where you stand? You can get an estimate of your benefits from Social Security’s online calculator.
Sanjib Saha is a software engineer by profession, but he's now transitioning to early retirement. Self-taught in investments, he passed the Series 65 licensing exam as a non-industry candidate. Sanjib is passionate about raising financial literacy and enjoys helping others with their finances. Check out his earlier articles.The post Marginal Benefit appeared first on HumbleDollar.
