When It Pays to Increase Your Earnings

Published on: 10:42AM Mar 10, 2013

We get this question from farmers approaching retirement age a lot:

"I have had very low income for most of my career and should I try to maximize my income as I approach retirement to increase my social security benefits"

Chris Hesse, who is one of my partners at CliftonLarsonAllen, LLP had provided me with an Excel spreadsheet that can calculate this answer fairly quickly.  It is based on the method that Social Security uses to determine your retirement benefits and the key issue for our farmer is what your average indexed monthly income has been during your career.

Social security benefits are calculated based upon the average of your highest 35 years of earnings indexed for inflation.  For example, the maximum wage that you could use for 2012 was $110,100.  In 1975 the maximum wage was $14,100, however the inflation index for that year was 4.98 so the equivalent 2012 number is about $70,200.  Therefore, you input all of your wages during your career and the computer then indexes them based on inflation.  It then takes the top 35 years and divides by 420 (35 years times 12).  This results in a very important number known as the Average Monthly Indexed Earnings (AMIE). 

The AMIE is then divided into three tiers.  The first tier (currently about $800) is valued at 90%.  The next tier (the next approximately $4,000) is valued at 32% and the remaining tier is valued at 15%.  Each of these tiers is then multiplied by these percentages and the cumulative result is your estimated monthly retirement benefit when you retire. 

Assuming a farmer has paid in the maximum amount for at least 35 years, the estimated monthly social security benefit at full retirement is slightly more than $2,500 per month.  However, the interesting part is how these tiers break down.

Tier 1 has a value of $712, Tier 2 $1,273 and Tier 3 is $565.  Tier 3 monthly earnings amount is calculated at about $3,800 which is almost 5 times higher than Tier 1, but the value of Tier 3 is about 20% lower than Tier 1.

The first step for our farmer is to maximize their Tier 1 AMIE amount.   If your average annual earnings have been less than about $10,000 indexed for inflation, then reporting greater farm earnings will dramatically increase your social secuity benefits.  For example. if a farmer during his career reported an average of $5,000 per year (in 2013 numbers), his current expected Social Security benefit is about $374 per month.  If over the next couple of years, he reports an extra $157,000 or so of earnings (does not need to be in one year), his monthly benefit will jump to about $712.  The extra social security cost will be about $24,000, but in return he will receive a lifetime annuity indexed for inflation paying $338 per month.  A simple calculation shows that he would fully recover his investment in about 6 years.

In our example, we are only trying to get up to the Tier 1 amount of about $800 per month.  As you go over Tier 1 into Tier 2, your return on investment drops dramatically.  Tier 1 has a 90% value, whereas Tier 2 only has a 32% value, therefore, as you enter Tier 2, instead of a 6 year payback, it becomes a 18 year payback.  Tier 3 amounts are even worse.  At that point, your payback period is in excess of 30 years.

In conclusion, if your earnings are still in Tier 1, it would definitely pay to pay in extra FICA tax to maximize your social security earnings.

Read more about maximizing Social Security.