How Does Social Security Work

How does Social Security work?

There are few areas of personal finance more confusing for people than Social Security. In this post, I’ll give you the basics of how Social Security works to help you make better decisions when claiming.

Here are the highlights of what we’re going to cover in today’s post.

We’ll get into a brief history of Social Security, the funding mechanism, who is eligible, and how the system calculates benefits. We’ll also discuss what the Social Security trust fund is and whether the system is and will remain solvent.

It’s important to know what happens when we file early and what happens when we wait. There are benefits to each. For most, it’s better to wait. I’ll tell you why that is. All of these things are important to those approaching retirement.

I would submit that it’s also important for the younger generation (Millennials, Xenniels, Gen Xers) to understand it. Many in the younger generation ignore Social Security in their planning. We often hear the argument that doing so increases the chances of retirement success.

Why? Not counting Social Security when calculating retirement income sources leads to saving and investing more money to assure there’s enough there to support the desired lifestyle.

I’ll share my thoughts on that as well.

A Brief History

President Franklin D. Roosevelt signed the Social Security Act into law on August 14, 1935.

Funded by taxes from workers, the original purpose of Social Security was as a retirement plan. It only paid benefits to the primary worker and participants could start benefits at age 65. Of course, life expectancies were much lower in 1935 than today. Payroll taxes were first collected in 1937 and the first payments to retirees came in 1940. Initially, the starting year was 1942. In 1939, via amendment, the start date became 1940.

Social Security numbers were assigned to workers as a way to track taxes collected and benefits accruing. The Social Security Trust Fund was the entity created to take in the taxes, manage the money, and pay out benefits.

Amendments in 1939 added spousal and children’s benefits. In 1950, Congress made provisions to increase benefits, which had remained fixed for the first ten years of retiree payments. In 1972, another amendment made automatic increases in Social Security benefits effective starting in 1975. Called the cost of living adjustments (COLAs), this adjustment increased payments to retirees based on the increase in the consumer price index.

Disability came about in 1954, while supplemental security income (SSI), designed to help the needy, came in 1972.

Funding for the trust fund has always been a topic for debate and discussion. I won’t get into that here but will talk about the current state of the trust fund shortly. If you want the complete history, go to Historical Background And Development Of Social Security.

A Word About Solvency

You hear a lot of talk in the media, the blogosphere, and the advice industry about the solvency of Social Security. That is a topic that gets discussed virtually every year. Let me give you some facts about the trust fund, and you can decide for yourself what to make of it.

The following information is from the 2016 year-end report.

Trust fund balance on 12/31/16:    $2.848 trillion

2017 results

  • Total income:   $996 billion
  • Total expenditures:   $952 billion
  • Net increase in assets: $  44 billion

Trust fund balance on 12/31/17:    $2.892 trillion

The Shortfall

Currently, there are more benefits paid out than taxes taken in, creating a funding imbalance. The chart below shows the impact of that imbalance. On its surface, it isn’t a pretty picture.

As you can see, the trust fund becomes insolvent in 2034. That means the reserves are depleted. Contrary to what you may have heard that doesn’t mean benefits stop. If nothing gets done, there would be an across-the-board benefits cut of 21%.

This is not the first time the fund has been in this situation. The last time the system was shored up was in 1983. At that time, payroll taxes increased as did retirement age. In essence, it was a punt, a kick the can down the road kind of thing. That’s been the nature of Congressional action on SSA for decades. That brings us to the current shortfall.

Potential Reform Proposals

It wouldn’t take earth-shattering changes to shore up the finances of the trust fund. Below are some of the things under consideration.

  • Increase maximum earnings subject to Social Security tax
    (currently $132,900 in 2019)
  • Raise the normal retirement age
    (currently 66 for individuals born between 1943 and 1954; 67 for those born in 1960 or later)
  • Lower benefits for future retirees
    (escalate benefits based on increases in consumer prices rather than wages)
  • Reduce cost-of-living adjustments (COLAs) for all retirees

Would these be painful for some? Of course. No one wants a cut in benefits or an increase in taxes.

However, most people want to see the system preserved. If history repeats itself, Congress will act at the eleventh hour to make the necessary changes to save the program. It will likely be another action that defers a permanent solution to a future Congress.

Benefit Calculation


Social Security retirement benefits consider two things.

  1. How much you earned during your working career
  2. The age at which you apply for benefits.

Age 62 is currently the earliest year to apply for benefits (the exception is a widow or widower, who can start at age 60).

When calculating the benefit, the Social Security Administration (SSA) adds up each year’s earnings for your working career. From there, they average the highest 35 of those years of earnings. That gives them the Average Indexed Monthly Earnings (AIME), which is the foundation for the rest of the calculation. Years where there was no income get included in the count as well.

Here’s why that’s important. The group most affected by this rule are mothers who quit their jobs to stay at home to raise their kids.

For simple calculations, let’s assume she had one child and stayed home until the child graduated high school. She goes back to work after graduation. When SSA looks back at her earnings history, there are 18 years of zero income. If, at age 62, those 18 years are part of the calculation. That can significantly lower her retirement benefit.

Bend Points

The SSA then divides the AIME into three “bend” points to come up with the monthly benefit.

For 2019, The first bend point is $926.00 and the second is $5,583.00. The income formula is progressive. That means two lower bend points get a much higher percentage attached to them when doing the calculation. The easiest way to illustrate this is with an example.

  • Baby Boomer born in 1957
  • Maximum Social Security earnings every year since age 22
  • AIME = $10,296
  • PIA formula:
  • $926 (1st bend point) x .90 = $833.40
  • $4,657 (2nd bend point) x .32 = $1,490.24 ($5,583 – $926 = $4,657)
  • $4,713 x .15 = $706.95 ($10,296 – $5,583 = $4,713)
  • Total = $3,030.59

PIA (primary insurance amount) = $3,030.50

Amount worker will receive at full retirement age.

Full Retirement Age (FRA)

The FRA is the age at which a worker will receive the PIA. In the example above, that’s $3,030.50. Full retirement age depends on the year of birth as follows:

Year of Birth Full Retirement Age

  • 1943-54                      66
  • 1955                            66 and 2 months
  • 1956                            66 and 4 months
  • 1957                            66 and 6 months
  • 1958                            66 and 8 months
  • 1959                            66 and 10 months
  • 1960 and later           67

A worker born between 1943 and 1954 (Boomers) would receive the $3,030.50 if they claimed benefits at age 66.

Claiming Before or After FRA

There are reductions in benefits for claiming before reaching FRA. The chart below shows the reduction.

Conversely, benefits will increase if claimed after FRA. The latest age to claim benefits is age 70.

The case for waiting is pretty compelling.

As you see from the chart, SSA adds 8% per year to the PIA amount at FRA. For those whose FRA is age 66, that amounts to an increase of 132%.

In the example above, for a Boomer who waits to claim until age 70, that $3,030.50 payment becomes $4,000.26. That’s an additional monthly benefit of $969.76 or $11,637.12 annually.

If they live another 20 years (close to the current life expectancy), they will receive an additional $232,742.40! That’s not a small amount of money.

Keep in mind that COLAs would be applied yearly. The SSA uses an average COLA of 2.8% in their calculation. Adding the inflation percentage to the calculation brings the total lifetime received to $306,409.48.

Since we’re just covering the basics for this article, I won’t cover spousal or survivor benefits.

Helpful links for SSA.Gov

To get your Social Security statement –
Retirement estimates –, click on “Estimate Your Retirement Benefits.”
Helpful calculators –

Final Thoughts

Claiming Social Security is not as simple as people try to make it. As I hope you see from our discussion, there are a lot of factors to consider. Maximizing your benefit for your specific situation is important to your retirement.

Let me summarize a few things to keep in mind when claiming.

  • If you apply early, your benefits will be lower permanently. They stay lower for life. Make sure that’s what you want before deciding.
  • COLAs increase the impact on what happens to your benefits. That’s true if you claim early or delay claiming. Typically, I advise using a longer life expectancy when planning for retirement. If you live longer than expected, you risk running out of money. From the Social Security perspective, planning to live longer means claiming later will give you the greatest benefit.
  • The decisions you make when you file affect your surviving spouse. If you claim early, their survivor benefit is lower. If you wait, the reverse is true.

Don’t rush to claim your benefit the first time you’re eligible. Take your time, coordinate the decision with your overall financial situation, and consider all your options.

After all, you’ve paid into the system your entire working life. You deserve to get the most out of it that you can.