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If you understand the way the benefit is calculated, you can estimate the consequences of working an additional year.
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If you have at least 35 years of earnings, it may be difficult to tell how much advantage you'll get from working another year. We would need to apply an inflation adjustment to each of the earnings amounts to find out which are the 35 highest years. Then we would have to identify the lowest year out of the 35 highest, because that is the year that will be replaced if you have an additional year with higher earnings. It's possible to work this out if you can locate the applicable inflation adjustments on Social Security Online, but it's beyond the scope of this discussion to work through all the details. Here's an example of how it might work out:
Example: You determine that your 35 highest years include 34 years with steady (and steadily increasing) earnings, plus one year you went back to school for additional training. You worked only a few months that year, earning $6,000. That was 25 years ago, and the relevant inflation adjustment indicates this is equivalent to $13,500 dollars today. If you work an additional year, earning $42,000, you'll replace a year valued at $13,500 with a year valued at $42,000, for an increase of $28,500. Divide by 420 to get an increase of about $68 in your average indexed monthly earnings.
The preceding examples show that two different people with the same amount of earnings in an additional year of work can see a different impact on their benefit calculation. You get more bang for your buck when you're replacing a year of zero earnings than when you're replacing a year that had at least some earnings that count in the calculation.
So far we've considered only the way your added earnings will affect average indexed monthly earnings (AIME). We have to apply the benefit formula to see how the increase in AIME will affect your benefit.
That formula provides benefits in three tiers. As a practical matter, anyone who is thinking about this issue of how an additional year of work will affect social security benefits is in either the second tier, where the 32% rate applies, or the third tier, where the 15% rate applies. People in the second tier get more than twice as much benefit from an increase in AIME as people in the third tier.
Example 1: Based on your earnings history, your retirement benefit is calculated at $1,000 per month. Working an additional year will add $42,000 to your earnings, increasing your AIME by $100. You are in the second tier, where the 32% rate applies, so the result will be a benefit of $1,032 per month.
Example 2: Based on your earnings history, your retirement benefit is calculated at $1,600 per month. working an additional year will add $42,000 to your earnings, increasing your AIME by $100. You are in the third tier, where the 15% rate applies, so the result will be a benefit of $1,615 per month.
The increase of $15 per month in example 2 may not seem like much, but you should bear in mind that it applies every month for the entire period you receive social security retirement benefits, and it will be adjusted for inflation over the years. It's likely to provide you with many thousands of dollars in additional benefits. Yet the increase of $32 per year in example 1 is more than double that amount. In a borderline case, that would be a much stronger incentive to work an additional year.
One way to find out which tier you're in is to determine your AIME, and see if it's above the second "bend point" in the benefit formula. (Bend points are explained in Step 5 on this page.) Unfortunately, it isn't easy to determine your AIME, because the process involves inflation adjustments to numbers throughout your earnings history.
There's an easier way, though. Based on the numbers in effect in 2005, you would have a benefit of about $1,570 at the top of the second tier. If your estimated benefit at full retirement age is at or above that number, you can expect additional earnings to fall into the third tier and produce the smaller 15% increment. Below that level your additional earnings will fall in the second tier and produce the larger 32% increment.
If you're using the estimated benefit from the annual statement you receive from the Social Security Administration, make sure you're looking at the benefit you would receive at full retirement age (even if you plan to retire early). Also, you have to take into account any additional earnings that are assumed in the statement. They assume you'll continue earning at the same rate as in your most recent year. If their calculation already assumes you'll make $42,000 next year, you won't see an increase in the full retirement benefit when you actually earn that amount because it was already assumed in the estimate. In this situation, working the additional year will prevent a decrease in the benefit relative to the estimate.
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