One of the most popular Social Security questions that I hear from baby boomers getting prepared for retire is "how are Social Security benefits calculated?" This is an important question as it could affect how long you need to work, whether you need to continue to work during your retirement years, or other aspects of your retirement plan.

Firstly, please note that you get a Social Security retirement benefit estimate each year in the mail, generally around your birth date. There're also several calculators available on the Social Security site to help you estimate how much your retirement benefits will be, so you do not require to know how to calculate the benefit yourself.

It is still helpful to know how Social Security is calculated, but, so here are the basics:

Generally, your top 35 years of earnings are indexed for inflation, then averaged to figure out the base for your monthly benefit. If you worked lower than 35 years, the missing years will be calculated as zero for purposes of determining your benefit amount.

Planning suggestion: If you have near 35 years of earnings and you are close to retirement, you'll benefit significantly by continuing to work until you have 35 full years of earnings to include in your benefit calculation. Most of the people it will affect are women who took time off work to raise a family.

The highest 35 years of earnings are then divided by 35 to arrive at your average indexed monthly earnings (AIME). A formula is applied to your AIME to figure out your primary insurance amount (PIA). We will not go into the specifics of the formula; the critical thing to note is that your Primary insurance amount is the full unreduced benefit you'd receive if you retired at your full retirement age (age 66 for people born between 1943 and 1954). This amount will be decreased if you take early retirement or increased if you retire after age 66.

The Primary insurance amount is also the basis for many other benefits such as spousal benefits, therefore it's critical to understand that your PIA is not always the same amount that you'll receive. If you are married and your spouse will be collecting benefits according to your earnings instead of her own, then you might want to maximize your own Primary insurance amount to maximize the total Social Security benefits you and your spouse will receive.

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