Introduction to Social Security: Part I (Overview)
Millions of Americans rely on Social Security as a source of income in retirement. Despite its importance, most only have a cursory understanding of the program – including how benefits are calculated, the best time to claim, and how much will be deducted from monthly disbursements to pay for Medicare Part B premiums (and/or potential surcharges). Also, recent changes to claiming strategies have left many people confused about what options they may have, and there are also separate guidelines for those who are divorced/widowed or have government pensions.
In short, Social Security is more complex than you think.
The Origin and Purpose of Social Security
In 1935, America established Social Security to provide a guaranteed income stream and some level of economic stability for those who were no longer able to work. Envisioned as a supplement to pensions and savings at a time when American’s lifespans were considerably shorter than today, the program has come under increasing financial strain.
With the shift away from pensions to 401(k) plans, Social Security has become an increasingly important source of retirement income – even though it only replaces about 40 percent of an average earner’s wages. Also, Medicare Part B premiums are directly deducted from Social Security benefits; therefore, as premiums rise and COLAs shrink (COLA was 0.0% in 2016 and 0.3% for 2017), more retirees can expect to see a reduction in their monthly checks.
How Social Security Works
Working Americans dedicate 6.2 percent of earnings into Social Security (up to $127,200 per year). Employers match this amount. These proceeds are not directly accessible; instead, the system pays it forward, and current contributions are currently being distributed to eligible beneficiaries. Any unused money goes to the Social Security Trust Fund.
Eligibility and Benefit Calculation
There are two components to calculating Social Security benefits:
1: a person must have worked at least 40 quarters (or 10 years); and
2: the amount received is based on the highest 35-year average of a person’s employment history.The Social Security Administration averages the top 35 earning years and converts them into a primary insurance amount (PIA) using a formula that favors those with low lifetime earnings.
Understanding Claiming and Full Retirement Age (FRA)
While Social Security can be claimed at 62, there is a financial penalty for doing so before full retirement age (FRA). FRA stands for the age in which the government recognizes an individual as able to collect full Social Security benefits without penalty. For those born before 1954, FRA is either 65 or 66. Anyone born from 1955 to 1959 has an FRA between 66 and 67. After 1960, FRA is 67.
Simply put: Social Security is set up to motivate people to defer claiming, and those who do this will reap significantly higher monthly benefits during their retirement. The earliest an individual may choose (or due to health or other personal circumstances, have no choice but) to claim Social Security benefits is age 62. However, someone claiming at FRA (in this case, 66) would gain 33.3% more. If that same person delayed claiming until 70 years old, he/she would earn 76% more than filing at 62.
Here is an example for someone who could earn $1,000/month at age 62:
As the table indicates, claiming age has an enormous impact on annual and lifetime earnings.