THE TAX ATTIC with Jerry Coon

How the SSA calculates benefits

Jerry Coon

Last week, I began a discussion on our Social Security system. The annual statement, beginning in May of this year, can only be accessed online. We went over the procedure for creating an account and accessing that online statement.

An important part of the annual statement is the data entered on page 3 titled “Your Earnings Record.” The record itemizes the earnings that the Social Security Administration (SSA) has on file for a taxpayer on a yearly basis.

In my case, I started working in 1970 and earned a grand total of $873 that year. I worked for a farmer that summer. The pay wasn’t that good but the fringes, especially the food, were excellent. The meals we ate were always “all you can eat;” heavy on the beef and potatoes. It was perfect for some hardworking farmhands plus it was a dairy farm, so fresh milk was always in supply. No one left the table hungry or thirsty! The last year posted on my record was 2010; 2011 had the note “Not yet recorded” instead of a dollar amount.

It’s important to look at the yearly wage figures and compare what your records show you earned versus what the SSA records say that you earned. Why is this important? The SSA calculates your monthly benefit based on what the SSA has for your earnings. If they are missing a year or missing a W-2 amount for one of the years, quite possibly this will affect the calculation of your monthly benefit. Remember that the SSA annually is processing millions upon millions of documents, both paper and the electronic versions. It’s not realistic to think there won’t be posting errors either by the SSA or by the employers. The error rate is estimated to be six to eight percent. I would bet that 100% of those errors are on the lower side of earnings, as opposed to overstating someone’s earnings. It pays to check.

The SSA uses these annual earnings to calculate a taxpayer’s monthly benefit. Let’s see if we can remove some of the mystery of how they decide what a monthly benefit should be.

For the initial calculation, the SSA looks at the annual earnings between the ages of 18 and 60. Only the earnings of the highest 35 years count.

The word “highest” needs clarifying. In the world of Social Security, earnings are upwardly increased based on an index called the National Average Earnings (NAE). The formula is: the NAE for the year before retirement divided by the NAE in the year being indexed. This result is then multiplied by the actual earnings for the year being indexed.

For example, as stated above, I earned $873 in 1970. Based on the indexing formula, the NAE for 2010 was $41,673.83. The NAE for 1970 was $6,186.24. So, $41,673.83/6,186.24 equals 6.74. We multiply my actual wage of $873 times 6.74 and that equals $5,884.02. Since the maximum wage upon which Social Security tax was paid was $7,800 in 1970, that means the indexing allows me to get credit for 75% of the maximum instead of only the 11% that I really earned. In 1980, I made $14,775. It seemed like that was a lot of money back then. When we go through the NAE indexing formula, that $14,775 becomes $49,200.75. In 1980, the maximum wage for Social Security purposes was $25,900. Even though I earned only 57% of the maximum, the NAE indexing allows my credit in the SSA formula to be 100%. I wonder who thinks these things up.

It’s easy to see that it’s particularly important to check those earliest earning years for errors. An $873 year became a $5,884.02 year when filtered the SSA’s formula. The” highest” of these indexed 35 years go into the formula. I have worked more than 35 years, so I will have a figure for each year. However, if I had worked only 25 years, 10 zeroes would go into the calculation.

Actually, this is the exact place at which women with children are highly discriminated against in the SSA system. First, substantial numbers of women miss out on several years of earnings while the children are growing but not in school. That can mean a number of zeroes in the formula.

Second, those missed years are the highest indexed years and therefore the most beneficial. Remember my 1980 figure through the magic of indexing allowed me to get 100% credit. If my wife, Deb, was not working but raising kids, she lost out on that indexed year. That error has never been and most likely won’t be corrected either.

Be that as it may, after adding up all of the indexed years’ earnings, the SSA divides that figure by 420 (35 years times 12 months). That result is called the Averaged Indexed Monthly Earnings amount or AIME.

For example, a taxpayer’s total indexed earnings are $1,512,000. The AIME equals $3,600 ($1,512,000/420). The AIME of $3,600 is then converted by a three-bracket formula to the taxpayer’s monthly benefit. Bracket one is the first $767 of the $3,600 of the AIME is multiplied by 90%. Bracket two is AIME in excess of $767 but less than or equal to an AIME of $4,624 is multiplied by 32%. Bracket three is AIME in excess of $4,624 is multiplied by 15%.

For our taxpayer, $767 times 90% equals $690.30; $3,600 minus $767 equals $2,833; $2,833 times 32% equals $906.56. Adding the $690.30 to the $906.56 equals $1,596.86. This is the monthly benefit the taxpayer would be expected to receive upon reaching full retirement age.

For reference purposes, the average monthly benefit paid out by the SSA as of January 2012 is $1,230 and the maximum benefit is $2,513 for those retiring at age 66. That puts our taxpayer just above average for SSA purposes.

The software on the SSA website does this calculation easily, but I think it is important for us to know how the software works. I depend upon software in my business, but it’s important to know and to be able to judge if the answer being calculated makes sense. This is Jerry Coon signing off.

Jerry Coon is an Enrolled Agent. He owns Action Tax Service on Northland Drive in Rockford. Contact Jerry at

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