How does retiring early impact Social Security benefits?

With the Great Resignation of the last two years, along with many people pursuing FIRE (financial independence, early retirement), there are many people who leave the workforce completely or pursue other passions that result in a lower paycheck.

You might think that these people are giving up a lot of Social Security benefits because of 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 very regressive. So when you give up this six-figure job at age 40, you may have only had Social Security income for 20 years (in many cases more than 15 years), but the lion’s share of the extra income doesn’t increase your income. future benefit of Social Security. a lot. If your 40-year-old income was the last to be applied to your Social Security, as if you were choosing to volunteer and make a living from your savings, the news of the impact on your benefit may surprise you.

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Once you’ve determined your average lifetime income, Social Security applies “hotspots” to calculate the amount of your primary insurance, which is the amount of benefit you will be paid at full retirement age. . In 2022, the first inflection point is $ 1,024 and the second is $ 6,172. Thus, the first $ 1,024 of your average lifetime indexed income is weighted at 90%; any amount above $ 1,024 and up to $ 6,172 is weighted at 32%; and amounts in excess of $ 6,172 are weighted at only 15%. See this link for a more complete explanation of bending points and how they are used to calculate the amount of primary insurance.

Below are these three figures from the bending point calculations for your Primary Insurance Amount (PIA).

For an early retiree, when there is less than 35 years of income (for example, 20 years) in your lifetime income record, Social Security will still average your income (indexing the years over the age of 60) as if there were 35 years to calculate. Therefore, 15 years will be zero in our example, which will definitely reduce the average of your life.

But seeing that the weights mentioned above are higher at the lower end of the middle income scale, one is beginning to realize that adding more years of high income does not necessarily lead to a significant increase in Security benefits. Social. You are taxed at the same rate (up to the annual tax limit), but your resulting profit does not increase to such a high rate.

Let’s take an example.

Meet Jeff, born in 1962. Jeff is 60 years old this year and overtook the FIRE curve because he earned enough during his career to quit his job at age 40 in 2002. Jeff maximized his Social Security income in each of these 20 years, and has not paid Social Security taxes since. His earnings from the age of 40 have been from passive investments, made with his high income during his 20 years of work.

Using Social Security calculations, we determine that Jeff is eligible for a $ 2,596 benefit if he or she waits until his or her full retirement age (FRA) of 67 years.

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Just to smile, what would it have been like if Jeff had continued to earn that high salary so far? If Jeff earned at least the maximum Social Security taxable amount for the full 40 years, the calculation results in a 67-year-old benefit of $ 3,377. About $ 9,400 (about 30%) more per year, but that’s in exchange for the extra 20 years Jeff had to get up at 2 a.m. each day to make the donuts. (You may notice that Jeff is a very well compensated donut maker, but you should try the fritters. They are amazing).

I understand this is an extreme example, so let’s look at Jeff’s twin brother, Jerry, who earned exactly $ 40,000 a year over the same 20-year period. If the age of 40 was the last year he worked, Jerry is eligible for a full retirement age benefit in the amount of $ 2,141. And if he had continued to work in the same job (no pay raise, this is the plight of the unfortunate Jerry) until he was 60 in 2022, the extra years of earnings would only increase his profit to $ 2,661 if he took it to 67 years.

That’s $ 520 a month ($ 6,240 a year), up 24 percent, again in exchange for getting up at 3 a.m. for another 20 years to scrub the floor after manufacturing. of his brother’s donuts.

But none of that was the real result for Jerry (and probably for many FIRE devotees): he actually launched his own bike shop in his 41st year, and has been running the store ever since. He was never as lucrative as his donut shop cleaning career, earning only about $ 20,000 a year, but it was enough to help him get out of it. Jerry has modest needs, and that income was enough to live on, when added to the passive investment income that Jeff had helped him organize.

With those extra 20 years of income to pursue his joy in life, Jerry is entitled to a full retirement age benefit of $ 2,453 a month, almost as much as Jeff earned with his high salary. for 20 years.

So the moral of the matter is that early retirement affects your Social Security benefits, but not as much as you might think, for many people. And partial retirement, such as pursuing a passion as a “next chapter,” may not affect 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 benefit of continuing to add to your earnings record can be spectacular. But at medium and, above all, higher profit levels, the impact is not so significant.

Note: I have specifically used people who are 60 years old this year in my examples because we have indexing information, inflection points, and maximum revenue amounts available for calculations. If I had tried to explain it to someone 40 years old this year, we would have to make many assumptions about how these facts and figures will unfold over the next 20 years. These are completely invented examples, in order to illustrate how early retirement affects Social Security benefits.

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