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Max recently blew past another financial milestone.

By the end of 2021, the Social Security Administration will have taxed me on just over a million dollars in earnings. If we adjust all those years of wages for inflation, we are looking at about $1.2 million in taxed earnings. Over my entire working years, the total tax out of my pocket will come out to about $66,017 by the end of 2021.

A $66,000 contribution to Social Security. Not bad.

That is much less than I would have guessed. I contributed about that much to my traditional 403(b) retirement account in the last four years alone through my most recent employer.

In most cases, the Social Security Administration taxes our earnings before those dollars even make it into our pocket. If you make W2 earnings like me, your employer likely takes it directly out of your paycheck at a rate of 6.2%. There were a few years mixed in there where we only paid 4.2%. But nobody remembers that.

But is this really a tax, or a government pension?

This million-dollar milestone got me wondering: how much is this $66,000 contribution worth to me at retirement? And if I were to stop working at the end of 2021, then what happens? You won’t see a lot of people asking this question. Heck, most people don’t understand the basics of the Social Security program. But I think this is something worth understanding as we start some long-term tax planning.

To start down the path of figuring that out, we will calculate Max’s Average Indexed Monthly Earnings.  

Max’s Slow and Consistent Earnings

Let’s start with some personal history.

Compared to other people in my college-educated bubbles, my salary history somewhat resembles the Tortoise and the Hare story. I would describe my professional earnings as initially slow, but consistent. In recent years, they have grown much more exponentially. Frankly, I have earned a good portion of my wages over just the last few years. If we were willing to move again, I could likely get another significant jump in salary.

The thing was when I graduated from Michigan State University, I did not have a hard technical skill to sell. Sure, I had a fancy generic business degree, but that was about it. I remember several of my classmates with computer science degrees landing high salaried positions in Chicago and out West.

Max, on the other hand, would move south to Tennessee, start at a much lower pay rate, and slowly catch them over time. My basic strategy was to just beat my ‘spendy’ friends on the expense side of the equation in those early years. Since my first job was nearly 100% travel with my employer covering most of my expenses, that was pretty easy. Hotels and free food pretty much covered everything. Could I have made a few moves differently to increase things on the salary side of the equation more quickly? Sure. But I am happy with how things panned out.    

Social Security – A Snap Shot

Let’s hit the basics of Social Security.

In 2021, the Social Security Administration will tax us 6.2% on all earnings up to a cap of $142,800. They don’t touch anything over that amount. This tax does not hit our investment income, only earnings from our jobs. Our employer also pays 6.2% into the program. They increase the cap each year, and I do not currently hit the $142,800 threshold. Things paid through a cafeteria plan like healthcare premiums are sheltered from the tax.

Those who do hit the income cap would pay a maximum of $8,854 into the Social Security system in 2021. Their employer would match that with another $8,854, for a total of $17,708.

Qualifying for the social security benefit at retirement age is a lot like school – you need enough credits to graduate. Forty credits, to be exact. Graduating takes about ten years of work since you can only receive up to four credits per year.

Qualifying for the four credits in any given year is not difficult. In 2021, you only need to make $5,880 to get all four credits. Many higher-income professionals can earn all four of their credits during the first couple of weeks of the year. I am sure some earn them in the first few minutes after the New Year. There is no “extra credit” either; the maximum number of credits you can get each year is four. You can check out your progress and get all of your earnings history over on the Social Security website.

Finally, we know Social Security is currently only funded through 2034. So there are likely structural changes in store for us prior to retirement. They could change the tax rate, go after investment income, or even bump back the age for eligibility. Either way, I fully expect this benefit to be there in some shape or form at the time of my formal retirement.

Max’s Social Security Credits

I earned most of my 40 credits well before I was even considered a ‘professional.’ A good chunk of those first forty credits came from cutting up chicken at Boston Market and delivering packages for DHL. Some days, I miss those jobs. So as I write this, I already qualify for Social Security benefits at retirement age.

According to the Social Security website, if I stay on my current income trajectory, I will gross about $2,770/month ($33,240 per year) at the full retirement age of 67 (in 2021 dollars). That’s enough to cover about 71% of our 2020 expenses. That doesn’t even including Mrs. Max OOP’s Social Security.

If I am healthy enough to hold my retirement until age 70, I will gross $41,472. We spent $46,207 in 2020. I consider this a good sign that contrary to popular opinion, Social Security is a good play to help us maintain our standard of living during our traditional retirement years. I am obviously not accounting for healthcare expenses.

But, as the website states, that is contingent on me working until retirement at my current earnings rate. I like this concept, as it encourages productivity.

But what would happen to my benefit if I were to completely stop working in 2021?

If we were to move to Canada or Australia one day, I suppose that could theoretically happen. I could potentially take a long hiatus from Social Security contributions.

Average Indexed Monthly Earnings

To understand the current value of my Social Security benefit, we need to start with my Average Indexed Monthly Earnings (AIME). Don’t let that word “indexed” scare you. Let me break this down.

• Average, because they average our highest 35 years of earnings.
• Indexed, because they adjust those earnings for inflation.
• Monthly, because it is reported back as a monthly figure (not annual).
• Earnings, because it only includes earned income from a job, not investment income.  

The Social Security Administration uses our Averaged Indexed Monthly Earnings as the starting point for figuring out our benefit at retirement age. Right now, they consider the “full” retirement age to be 67.

They calculate our average monthly earning by averaging our highest 35 years of earnings. Their smart actuaries index our earnings to account for inflation.

For example, I made $2,734 at Boston Market way back in 2000 and that got me three of my forty credits. That figure is now worth $4,600 in 2021 dollars. You can find the index figures for each year here. They change every year.

$2,734 (wages earned in 2000) X 1.6824846 = $4,600 (value in 2021 dollars)

I worked all through high school and college, so I already have about 20 years of earnings on record with the Social Security Administration. My total earnings come out to about $1 million earnings over 20 years when I include my projected 2021 earnings.  

When we index all of the years for inflation, I come up with $1,234,730.

But even though I only have 20 years of earnings under my belt, I am still required to divide my total lifetime earnings by 35 years to calculate my average indexed annual earnings. In other words, they fill the earnings of 15 of my 35 years with big fat zeros. That brings down my average dramatically.    

$1,234,730 / 35 years = $35,278/year = Average Indexed Annual Earnings 

I then divide this by 12 to get my Average Indexed Monthly Earnings

$35,278 / 12 months = $2,940 = Average Indexed Monthly Earnings

This $2,940 is the starting point for my Social Security benefit calculation. It represents what I made on average per month during my highest-paid 35 years in today’s dollars.  

Final Thoughts

Taking the time to understand how some of this stuff works is a good use of time. A great place to start is calculating your AIME. You might find those years working at a fast-food restaurant still pay dividends.

I find this part of the calculation straightforward and simple math can get us there. We are averaging 35 years of earnings history and adjusting it to the current year’s dollars. This basic calculation gives us our Average Indexed Monthly Earnings. Since I am relatively early on in my career, my AIME is heavily averaged down by 15 years of $0.00 in earnings, and a handful of years of marginal fast-food wages. The chicken was good, though.

Therefore, at the end of 2021, mine will come in at $2,940. It will only go up from here.

But the Social Security Administration is not going to pay me $2,940 per month at retirement. I will only get a portion of that when I hit retirement age.

So, from here, things get a bit more complicated. When calculating our monthly benefit at retirement, the Social Security Administration only pays us a portion of our Average Indexed Monthly Earnings. But it is not as straightforward (think marginal tax brackets) so we will save that for another blog post.

What is your Average Indexed Monthly Earnings to date?