Knowing two basic things about Social Security are crucial in balancing your plans, even when you’re young, about tax planning and retirement planning –
1) How do I qualify to collect Social Security?
You should have earned 40 credits worth of qualifying income which includes self employment and wages from work by the time you apply for Social Security benefits. It does NOT include S-Corp dividends that were not subject to the SE, as well as net rental income or investment income. One credit is currently equal to $1320 in qualifying income and is indexed for average wage growth. You can earn up to four credits max in a year and need 40 credits at least in order to be able to collect benefits.
Your Full Retirement Age will vary some depending on when you were born, for those born after 1960, full retirement age is 67. You may be able to collect a bit earlier and receive reduced benefits, or wait longer and receive higher benefits. Ultimately, your benefits are calculated based on income and then spread over the entire time of assumed mortality, so you are expected get the same amount in total if you live as long as they think you will, but the monthly amount will vary based on how long you divide those payments for.
2) How are my Social Security Benefits calculated?
Social Security takes your highest 35 years of earnings adjusted for inflation. Keep in mind if you haven’t accumulated 35 qualifying years, the Social Security Administration will count those missing years as zero and include that in your calculation. That total is then divided by 420 (Number of months in 35 years). This is your Average Index Monthly Earnings (AIME).
After your AIME has been determined the Administration applies the following progressive formula:
90% of the first $896, then 32% of $896 to $5399, and finally 15% of the amount over $5399.
This calculation results in your Primary Insurance Amount (PIA).
As an example take someone with an AIME of $6000 and determine their PIA
90% of $896= $806
32% of (5399-896)= $1441
15% of (6000-5399)= $90. This persons PIA at full retirement age (FRA) in this case is $2,337. (full retirement age for those who were born in 1960 and later is 67, for those born prior to 1960 full retirement age is a less)
The highest monthly benefit in 2018 for those who have reached Full Retirement Age is $2788.
Why is this important?
Many people spend all their working years trying to minimize taxes at the expense of their social security payments. Sole proprietors who are overly aggressive with their expenses, people working “under the table”, unreported tips and people with S-Corporations who don’t take meaningful “Reasonable Compensation” will likely find themselves short once they apply to collect their benefits. Additionally, contributions to Social Security are also used to calculate benefits should you become permanently disabled or your kids benefits should you pass away while they are still minors.
I am all about saving taxes where legitimate and appropriate, but you should keep in mind that what you do today could have an effect on what you get in the future. Knowing this information can help inform some of your important decisions at tax and retirement planning time so the sooner you are aware the better.
We’ll chat again soon.