Austin, Texas – Employees who pay the FICA or federal payroll tax are likely to see an impact on their Social Security benefits in the future. Understanding how these benefits are calculated is crucial to preparing for retirement. Social Security benefits are determined based on the highest 35-year average of indexed wages, not on a “high-three average salary” like other retirement benefits. This calculation involves adjusting wages earned throughout one’s career to reflect their value two years before becoming eligible for Social Security retirement benefits, typically at age 60 for individuals eligible at age 62.
Social Security uses the National Average Wage Index to establish a new index every year, reflecting the national average annual wages of income subject to federal income tax. The amount of indexed wages plays a significant role in determining one’s Average Indexed Monthly Earnings (AIME) and eventual benefit payable at Full Retirement Age. Lower-wage earners may receive a higher replacement of income through the benefit calculation formula to ensure financial security in retirement.
In 2024, the maximum earnings subject to the Social Security payroll tax increased to $168,600 from $160,200 in 2023. This increase impacts the calculation of the high-35 average indexed wage amount, limiting the amount used in computing AIME for future benefits. The system is designed to favor lower-wage earners, but challenges, such as the Trust Fund deficit projected for 2034, pose potential threats to the sustainability of Social Security benefits.
Proposals to address the Trust Fund deficit include eliminating the taxable earnings base, thereby subjecting all earnings to taxation. Such proposals could delay Trust Fund depletion by about 20 to 26 years, providing increased revenue to cover a significant portion of the projected shortfall. However, policy changes, such as an increase in the payroll tax rate, may be necessary to ensure the solvency of the system for the next 75 years. Maintaining a link between taxed wages and benefits is essential for the long-term stability of Social Security.
The 3.2% cost-of-living adjustment announced in October 2023 impacted more than 66 million Social Security beneficiaries in January 2024, increasing their benefits. While this adjustment represents a decline from the previous year, it remains above the average over the past few decades. Understanding how the COLA affects the Primary Insurance Amount (PIA) and eventual benefit payments is essential for retirees to make informed decisions about claiming Social Security benefits at different ages.
Whether claiming benefits early or late, the COLA adjustment is applied to the PIA to reflect changes in the cost of living. Understanding the nuances of benefit calculations, including adjustments for age and delayed retirement credits, can help individuals maximize their Social Security benefits. Staying informed about changes in Social Security policies and benefit calculations is crucial for everyone paying into the system to ensure financial security in retirement.