For many Americans, Social Security provides a base of income protection in retirement. But if you're under the assumption that what you paid into the system is exactly what you'll get out of it, here's what you need to know.
Social Security works differently than your 401(k) or other qualified retirement plans. For example, with a qualified retirement plan, your future income from those assets will depend on their value when withdrawals begin. Social Security benefits, however, aren't calculated so simply. Unlike contributions to a private retirement plan, you're not necessarily going to have a return based upon market performance. Instead, the Social Security Administration (SSA) uses a benefit formula1 to calculate how much you'll receive come retirement.
The Social Security Formula
If you retire at your full retirement age, your retirement benefit will be 100 percent of your primary insurance amount (PIA). Your PIA is calculated by applying a benefit formula to your average indexed monthly earnings (AIME). In other words, if you had high earnings over your lifetime, your benefit will be larger than the benefit of someone who had lower earnings.
However, because the Social Security benefit formula is meant to help low earnings individuals supplement their income, the system's formula is heavily weighted to favor individuals with lower earnings - actually enabling them to receive a greater percentage of what they put in versus someone with higher earnings. For example, a higher wage earner may receive 50 percent of their AIME giving them a larger payout, while someone who earned substantially less could very well receive 65 percent of their AIME according to the formula. So while the dollar amounts may differ, someone earning less may get a larger percentage of their AIME.
Retirement planning is all about ensuring that you have enough money to carry you through your golden years, and Social Security plays a big part in that process. And though you can't change Social Security's benefit formula, you can make some decisions during your lifetime that will affect the amount of your benefit.