Essential things to know about your Social Security benefit: Part 1

Today’s column is aimed at everyone who pays or has paid the FICA or federal payroll tax. Employees pay 6.2% of gross wages towards Social Security cash benefits and 1.45% towards Medicare hospital insurance tax or Medicare Part A. Your employer matches these percentages  for a 15.3% total tax. It is important to keep up with Social Security changes that can have an impact on your current benefits and the benefits you will receive in the future.     

An annual change that will impact your future Social Security benefit 

Have you ever wondered how your Social Security benefit amount is determined?  Instead of a “high-three average salary” like the one used to determine your CSRS or FERS retirement benefit, Social Security computes your benefit on the highest 35-year average of your indexed wages. Indexed wages are simply your wages that were earned throughout your career that have been adjusted to the value that wage would have if it were earned two years before you become eligible for Social Security retirement benefits – usually at age 60 if you become eligible at age 62.

To do this, Social Security uses the National Average Wage Index. A new NAWI is established every year based on the national average annual wages of income subject to federal income tax (including contributions to deferred compensation plans like the Thrift Savings Plan).   

For example, a person retiring at age 62 in 2024 would have their wages indexed to the NAWI for 2022 (age 60), or $63,795.13. Let’s say that in 1992, this person earned $21,986 in annual wages. This would be multiplied by an index factor of 2.7815, making the “indexed” wage for the 1992 earnings equal to $61,154. The index factor resulted from the NAWI of 2022 ($63,795.12) divided by the NAWI for 1992 ($22,935.42), which equals 2.7815. The highest 35 years of indexed wages are added and divided by 420 months (35 x 12) to equal your Average Indexed Monthly Earnings. A portion of your AIME is multiplied by 90%, another portion by 32%, and if your AIME is high enough, the last portion is multiplied by 15% to equal the benefit payable at your Full Retirement Age. The higher your AIME, the smaller the replacement, as the formula reduces from 90% to 32% to 15% of your AIME. This formula intentionally provides a greater replacement of income to lower-wage earners who may not have had enough savings or pension benefits to retire financially secure. 

Maximum taxable wage amount 

The maximum earnings subject to the Social Security payroll tax rose to $168,600 in 2024 from $160,200 in 2023. This also limits the wages used to compute your high-35 average indexed wage amount. For example, if you earn $250,000 in 2024, you will only pay the 6.2% payroll tax on the first $168,600. This limits the amount used to compute your AIME when you claim your future benefit which is another way the Social Security benefits are tilted towards the lower wage earner.   

One possible solution to the looming Trust Fund deficit coming in 2034 is changing the income amount subject to the FICA tax. When payroll taxes for Social Security were first collected in 1937, about 92% of earnings from jobs covered by the program were below the maximum taxable amount. More recently, in 2020, about 83% of earnings from employment covered by Social Security fell below the maximum taxable amount. 

According to a 2021 Congressional Budget Office report, the SSA’s Office of the Chief Actuary analyzed several proposals that involve eliminating the taxable earnings base so that all earnings are taxed. These proposals push SSA Trust Fund depletion back by about 20 to 26 years. If no equivalent benefit increase is provided for earnings above the current taxable earnings base, the increased revenue would eliminate 73% of the projected shortfall. Under this scenario, the payroll tax rate would need to be increased from 12.40% to about 13.36%, or other policy changes would have to be made so that the system would be solvent for the next 75 years. However, the traditional link between the level of wages that is taxed and the level of wages that counts toward benefits would be broken. See the most recent Annual Report on the Social Security program's financial status to learn more about the deficit.   

Annual change that impacts you if you are eligible or are receiving your benefits: 

The 3.2% cost-of-living adjustment (COLA) was announced in October 2023 and increased the benefits payable to more than 66 million Social Security beneficiaries in January 2024.  The 2024 COLA represents a significant decline from last year’s 8.7% adjustment but is still above the 2.6% average over the past few decades. All Social Security recipients feel an impact from the annual COLA, though it varies depending on factors such as your type of benefit and when you claimed it.   

A deeper dive into the SSA cost of living adjustment 

The COLA is applied to your Primary Insurance Amount, which is the value of your Social Security benefit payable at your  your FRA, which is age 67 if you were born in 1960 or later.  For example, if your initial PIA is $2,200 and then it is increased by a 3.2% COLA, the new PIA would be $2,270.40.  If you claim Social Security retirement benefits before your FRA, your benefit will be reduced based on how much younger you are than your PIA. On the other hand, if you choose to retire after you attain your FRA, your benefit will be higher than your PIA because of delayed retirement credits. You can learn more about claiming Social Security early or late with the When to Start Receiving Benefits fact sheet. Regardless of the age when you claim your benefit, the COLA adjustment is always applied to the PIA and then adjusted for age.