Warning, this is a longer post than normal, but I think it important information for everyone, not just farmers facing retirement.
As farmers start to approach retirement age, many will ask how much extra self-employment or wage income should they report in order to "maximize" their social security benefits. The answer, as always, it depends. If they have paid in little or no FICA tax during their career (pushing the tax down the road or using commodity wages), then paying a larger chunk into SS may make sense.
The calculation of social security can sound complicated, but in general it works as follows:
- You take your highest 35 years of indexed income. Each year before you reach age 60 has an indexed factor. Once you reach age 60, this factor remains at 1 until you elect to retire. For example, if you were born in 1953 and earned $20,000 in 1990, your factor would be 2.1347 and this would equate to indexed earnings of $42,694. This would be what is entered for your "1990" earnings.
- All of these indexed annual earnings are accumulated and then they take the 35 highest indexed earnings amounts and then divide by 420. This number is referred to as your "Average Indexed Monthly Earnings" (AIME). This is not what you will collect.
- Each year, two bend points are calculated. The current US Average Wage Index is determined. This number is then divided by the Average Wage Index from 1979 (wage ratio) and then is multiplied by $180 to arrive at the first bend point. For example, in 2019, the Average Wage Index is $50,321.89 and the index is 1979 was 9,779.44. Doing the math results in a first bend point for 2019 of 926.22 (rounded to $926). If this number is less than $926, it is multiplied by 90% to arrive at your monthly earning amount (based on the first bend point). For example if your AIME is $900, you would receive $810 (based on full retirement age).
- The next bend point uses the same math, but instead of multiplying your wage ratio by $180, you multiply by $1,085. For 2019, this number is $5,583.07 (rounded to $5,583). All of your AIME between $926 and $5,583 is valued at 32%. For example, assume your AIME is $5,000. The first $926 is valued at $833.40 and the next $4,074 ($5,000-$926) is valued at 32% or $1,303.68. Your total monthly benefit would be $2,137 (rounded).
- Finally all dollars generated after the second bend point is valued at 15%. For example, assume your AIME is $10,000. The first $926 is $833.40, the next $4,657 ($5,583 - $926) is valued at $1,490.24 and the last $4,417.00 is valued at 15% or $662.55. This results in a final monthly benefit of $2,986 (rounded).
Therefore, it is very important to know which bend point you have passed over. If you still have not reached the top of the first bend point, it makes all the sense in the world to maximize that as quickly as possible. The payback on filling that bucket is very short.
As example, assume you report an additional $10,000 of income and pay $1,530 of self-employment tax. Your AIME adjustment would $23.81 and you would get credit for 90% of this number or $21.43. If we simply divide $1,530 by $21.43 we come up with 71.4 months or about 6 years to break even (this does not include any time value of money which may push it out a few months).
However, if you are past the first bend point and before the second, the value of the $23.81 now drops to 32% or $7.62. This now takes at least 200 months to break even (or 16.7 years). This does not reflect time value of money which may make it even longer. However, social security is indexed for inflation so the break-even period is likely pretty close to this number.
Finally, if you are past the second bend point, your $23.81 monthly increase is now only valued at 15% or $3.57. This now takes 429 months or 35.75 years.
The conclusion is if you have not reached the first bend point, pay in as quickly as you like. If you are past the first, it will take at least 17 years to break even. If you are in good health and want to make sure you do not run out of income, then investing your funds in this area has some merit, but substantially less than being in the first area. Finally, if you are past bend point #2, don't waste your funds. You can take the money you don't invest in social security tax and likely do much better investing in stocks, bonds or more farm land.