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Understanding Social Security: How does retiring early impact Social Security benefits?


With the Great Resignation over the past couple of years, along with a lot of folks pursuing FIRE (Financial Independence, Retire Early), there are a lot of people who are either dropping out of the workforce altogether or pursuing other passions that result in a lower paycheck.

You might think that these folks are giving up an awful lot of Social Security benefits due to the way your benefit is calculated, but it’s not as bad as you might think. 

This is because the way Social Security benefits are calculated is highly regressive. So when you resign that six-figure job at age 40, you may have only had Social Security earnings for 20 years (in many cases more like 15 years), but the lion’s share of any additional earnings is not increasing your future Social Security benefit much. If your age-40 earnings were the last that applied to your Social Security, such as if you chose to take on volunteer work and live off your savings, the news about the impact to your benefit may surprise you. 

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Once your lifetime average earnings have been determined, Social Security applies “bend points” to calculate your Primary Insurance Amount, which is the amount of benefit you will be paid at Full Retirement Age. In 2022, the first bend point is $1,024, and the second is $6,172. So the first $1,024 of your indexed average lifetime earnings is weighted at 90%; any amount over $1,024 and up to $6,172 is weighted at 32%; and amounts over $6,172 are weighted at just 15%. Check out this link for a more complete explanation of bend points and how they are used for calculating the Primary Insurance Amount. 

Those three figures from the bend point calculations are then added together to result in your Primary Insurance Amount (PIA). 

Regarding an early retiree, when there are fewer than 35 years worth of earnings (for example, 20 years) in your lifetime earnings record, Social Security will still average your earnings (indexing the earlier years to your age 60 year) as if there were 35 years to calculate. So 15 years will be zeros in our example — which will certainly bring down your lifetime average. 

But seeing that the weightings mentioned above are highest at the lower end of the average earnings scale, one begins to realize that adding more years of high earnings doesn’t necessarily result in a significant increase in Social Security benefits. You’re taxed at the same rate (up to the annual taxation limit) but your resulting benefit doesn’t increase at such a high rate. 

Let’s walk through an example. 

Meet Jeff, born in 1962. Jeff is 60 this year, and he was ahead of the FIRE curve, because he earned enough in his career to quit work altogether at age 40, in 2002. Jeff maxed out his Social Security earnings in each of those 20 years, and ever since then has not paid tax into Social Security at all. His earnings from age 40 forward have been from passive investments, made from his high income during his 20 working years.

Using Social Security’s calculations, we determine that Jeff is eligible for a benefit of $2,596 if he waits until his Full Retirement Age (FRA) of 67. 

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Just for grins, how would it have turned out if Jeff continued earning that high-level salary up to this point? If Jeff earned at least the maximum Social Security taxable amount for the full 40 years, the calculation results with an age-67 benefit of $3,377 for him. Roughly $9,400 (approximately 30%) more per year, but that’s in exchange for the additional 20 years that Jeff had to get up at 2 a.m. every day to make the doughnuts. (You may note, Jeff is a very well compensated doughnut maker — but you should try the doughnuts. They’re amazing.) 

I realize this is an extreme example, so let’s look at Jeff’s twin brother Jerry, who earned exactly $40,000 per year over the same 20-year period. If age 40 was the last year that he worked, Jerry is eligible for a Full Retirement Age benefit in the amount of $2,141. And if he had continued working in that same job (with no increases in pay, this is the plight of the hapless Jerry) until his age 60 in 2022, the additional years of earnings would only increase his benefit to $2,661 if he took it at age 67. 

This works out to $520 more per month ($6,240/year), about 24% increase — again, in exchange for getting up at 3 a.m. for 20 more years to mop the floor after his brother’s doughnut-making. 

But neither of these was the real outcome for Jerry (and likely for many FIRE devotees) — he actually launched his own bicycle shop in his 41st year, and has been running the shop ever since. It was never as lucrative as his doughnut shop mopping career, making only about $20,000 each year, but it was enough to help him get by. Jerry has modest needs, and this income was plenty for him to live on, when added to the passive investment income that Jeff had helped him to arrange. 

With this extra 20 years’ worth of income from pursuing his joy in life, Jerry is due a Full Retirement Age benefit in the amount of $2,453 per month — almost as much as Jeff earned with his very high salary over 20 years. 

So the moral of the story is yes, retiring early does impact your Social Security benefit, but not as muchl as you might think, for many people. And partial retirement, such as pursuing a passion as a “next chapter,” may not impact your Social Security as much as you’ve been led to believe. 

If the earnings record in question was at the lower end of the spectrum, the advantage of continuing to add to your earnings record can be dramatic. But at the middle and especially the highest earnings levels, the impact isn’t as significant. 

Note: I specifically used individuals who are age 60 this year in my examples because we have the indexing information, bend points, and maximum earnings amounts available for calculations. Had I attempted to explain this for someone aged 40 this year we’d have to make a lot of assumptions about how those facts and figures will play out over the coming 20+ years. These are completely contrived examples, for the purpose of illustrating how retiring early impacts Social Security benefits.

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