Social Security is a critical source of income for millions of retired workers. But very few Americans know exactly how their retirement benefit is calculated. While memorizing the process is unnecessary, simply understanding the steps involved can help retired workers make more informed financial decisions.

Here's a step-by-step explanation of how Social Security benefits are calculated.

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Step 1: Lifetime earnings are indexed to account for wage inflation

Social Security is based on lifetime earnings. The first step in calculating retired-worker benefits is adjusting (or indexing) earnings to account for changes in general wage levels over time. Doing so ensures retirement benefits reflect any increase in living standards realized while the worker was employed.

Workers are eligible for retirement benefits at age 62. At that point, the Social Security Administration uses the Average Wage Index (AWI) to adjust income earned in each year before the year in which the individual turned 60. Here's an example based on a hypothetical worker who reaches eligibility in 2025.

1. The AWI for 2023 ($66,621.80) is divided by the AWI for 2022 ($63,795.13). The quotient of 1.0443 is multiplied by the worker's income in 2022.
2. The AWI for 2023 ($66,621.80) is divided by the AWI for 2021 ($60,575.07). The quotient of 1.0998 is multiplied by the worker's income in 2021.
3. This process is repeated for each year in which the worker was employed until all income has been indexed to the AWI in 2023.

To summarize, the first step in determining retired-worker benefits is indexing earnings to account for changes in general wage levels. The indexing process begins two years before the worker turns 62. So the AWI from 2023 would be used for workers who become eligible in 2025. Alternatively, the AWI from 2022 would be used for workers who became eligible in 2024.

Step 2: Indexed earnings from the 35 highest-paid years are averaged

Importantly, the Social Security Administration only considers income above the maximum taxable earnings limit, which is adjusted annually to account for changes in the AWI. The maximum taxable earnings limit is $176,100 in 2025. Income above that level is exempt from Social Security payroll tax, and it's also excluded from the indexing process.

Next, the Social Security Administration identifies the 35 years in which indexed earnings are the highest, and the income from those years is added together and divided by the total number of months in those years to determine the average indexed monthly earnings (AIME) amount. The AIME will be run through a formula in the next step to determine the primary insurance amount (PIA) for the retired worker.

Step 3: A formula is applied to the average indexed monthly earnings (AIME) amount

The benefits formula consists of two bend points, which are updated annually to account for changes in the AWI. The formula is used to find the PIA, which is the benefit a retiree will receive if claiming Social Security at full retirement age. The PIA equals 90% of the AIME below the first bend point, plus 32% of the AIME between the first and second bend points, plus 15% of the AIME above the second bend point.

The bend points for those who become eligible for Social Security (i.e., reach age 62) in 2025 are $1,226 and $7,391. So, a retiree with an AIME of $10,000 would have a PIA equal to the sum of the following:

• 90% x $1,226 = $1,103.40
• 32% x ($7,391-$1,226) = $1,972.80
• 15% x ($10,000-$7,391) = $391.35

The sum is $3,467.55. That means a retired worker who becomes eligible for Social Security in 2025 and has an AIME of $10,000 will have a PIA of $3,467.55. That sum is equivalent to the worker's monthly benefit if claiming Social Security at full retirement age. But that same worker will get less if claiming earlier and more if claiming later.

Step 4: The primary insurance amount is adjusted for inflation, as well as early or delayed retirement

To summarize, earnings are first indexed to account for changes in general wage levels. The indexed earnings from the 35 highest-paid years of work are then converted to a monthly average known as the AIME. And the benefits formula is then used to find the PIA, the sum of three separate percentages that represent portions of the AIME.

Finally, the Social Security Administration adjusts the PIA for early or delayed retirement. Workers who claim Social Security before full retirement age receive a reduced benefit, meaning less than 100% of their PIA. And workers who claim Social Security after full retirement age receive an increased benefit, meaning more than 100% of the PIA.

Importantly, retired workers cannot claim Social Security before age 62 and it would be nonsensical to claim Social Security later than age 70, because there is no advantage to delaying beyond that point. Put differently, retirees will receive the smallest benefit at age 62 and the largest benefit at age 70 based on their individual circumstances.

In addition, a retired worker's PIA is adjusted for inflation through annual cost-of-living adjustments (COLAs) starting when reaching age 62. COLAs are applied to the PIA whether the individual has claimed Social Security or not.