SUMMARY: Although millions of people plan on using Social Security to make up part of their retirement income, how the program actually works is still a mystery to many of them. Here's an overview of the basics.
Where Does Social Security Come From?
Social Security is officially called Old Age, Survivors and Disability Insurance, and is run by the Social Security Administration. It was started during the Great Depression because the majority of retirees at the time were living in poverty.
How Does Social Security Work?
The program taxes working individuals and then pays benefits to retirees and those who are unable to work due to disability. If you look at your pay stub, this tax is either the majority of your FICA withholdings or marked separately as Social Security. If you're self-employed, it accounts for 12.4 percent of the 15.3 percent self-employment tax.
These taxes are used to pay current benefits for people who are already retired or on disability. The government is not investing the money for you as some people mistakenly believe. The one exception is that if the taxes collected exceed the benefits paid, the surplus is paid into the Social Security Trust for future use.
How Do You Qualify for Social Security?
To receive retirement or disability benefits, you generally must have worked for the equivalent of at least 10 years.
You are considered to have worked for 10 years when you have earned 40 Social Security Credits. You can earn up to four credits per year. In 2018, you receive one credit for each $1,320 in eligible annual earnings.
To be eligible, your earnings must be subject to Social Security taxes. Most employment and self-employment is. There are a small number of exemptions for things like certain religious groups, and some government jobs participate in a separate benefits program.
How Are Benefits Calculated?
Other than the minimum number of credits, there are two steps to calculating your retirement benefits.
First, your top 35 years of earnings are averaged. The higher the average, the higher your annual benefit. This benefit is known as your Primary Insurance Amount.
One thing to note about your PIA is that it's based on a progressive scale like the tax code. While increasing your income increases your benefits, it isn't directly proportional. In addition, there is a cap on your income and Social Security taxes. In 2018, only your first $128,400 in earnings will be taxed and included when calculating your PIA.
Your PIA is then adjusted based on when you retire. The base age, where your PIA equals your annual benefit, is from 65 to 67 depending on when you were born.
You can begin receiving benefits as early as age 62. In this case, your annual benefit would be reduced below your PIA because you are receiving benefits longer.
Similarly, if you wait until as late as age 70 to begin receiving benefits, you will receive a higher benefit.
Spouses can opt to claim either their own benefit or one half of their spouse's. This helps in situations where one spouse earned significantly more than the other. If the higher-earning spouse dies, the surviving spouse can then opt to claim the other spouse's entire benefit.
Disability benefits are calculated similarly to retirement benefits. If a younger worker becomes disabled, they may be able to qualify based on a reduced number of benefits and to have their earnings averaged over a shorter period of time.
To learn more about Social Security, such as tax strategies and how retirement income impacts your benefits, download our free Social Security guide.