Social Security has a flat 6.2% tax rate, up to the maximum wages covered by Social Security ($117k in 2014). Social Security benefits bear some positive relationship with your covered wages and the amount of taxes you paid on those wages. The higher your covered wages, and the higher the 6.2% Social Security taxes you paid, the higher your benefits.
Social Security calculates benefits using your average earnings over 35 years. If you work less than 35 years, the rest of the years will be filled with zero. Therefore, up to 35 years, the more years you work, the higher your average earnings. Retiring early, before you have 35 years of working history, means that your Social Security benefits will be lower.
However, it’s not a straight line. You get more credit for your earnings at the lower end than you do at the higher end. The points at which the crediting percentage changes are called bend points.
There are two bend points. The first one is set low ($816/month in 2014). For most people, the second point is the more meaningful one ($4,917/month in 2014). After your average earnings over 35 years reaches the second bend point, for each dollar in additional average earnings, you get less than half as much in Social Security benefits as before (15% vs 32%).
Think of these bend points similar to tax brackets. If your extra income gets into a 70% tax bracket as there once existed, you don’t have much incentive to earn the extra income. Similarly, if your earnings history already put you beyond the second bend point, you are not getting as much bang for your additional years of work as far as your Social Security benefits are concerned. If you think of your Social Security tax as forced savings for your own retirement, which it isn’t, after you reach the second bend point, you are definitely paying for other people’s retirement for the most part.
If you stop working after you reach the second bend point, even if your future earnings are zero, you are not losing much in Social Security benefits. If you retire before you reach the second bend point, you are losing twice as much in Social Security benefits.
So the question is when you will reach the second bend point. I created a spreadsheet to answer this question. You enter the year you started working. By default the spreadsheet pulls in the maximum wages covered by Social Security for each year. You can overwrite it with your own earnings history or future estimates. You get your earnings history from the paper statements Social Security used to send out. You can also get them from Social Security’s website if you create an account.
My spreadsheet is only for a rough estimate. It covers maximum 35 years of earnings history. It uses today’s dollars for the future, assuming your earnings will keep pace with the national average wage index.
The answer for me is that I will reach the second bend point in 2016. That’s about 20 years since I started working full-time. If you had a higher income than I did, you will reach that point sooner, or later if you had a lower income. If you want to know when you will reach the second bend point, try the spreadsheet.
[Photo credit: Flickr user AJ]