Are you not sure how much money to put aside for retirement? Start a personal Social Security fund. Social Security was originally designed to get you through your retirement years, but it's unclear whether it will be around for decades to come. While you can't stop paying Social Security tax from your paycheck, you can create your own additional fund for yourself using the same percentages. (For more, see our Introduction To Social Security.)
The Formulas Behind Social Security
Social Security is calculated on a percentage basis, based on how much money you make and whether you are self-employed or employed by someone else. Throughout this article, a person making $40,000 per year will be used as an example, for easy comparisons.
- As of 2010, self-employed individuals paid 10.6% of their income up to the first $106,800 of their earnings. For example, if you make $40,000 this year, $4,960 will go towards Social Security.
- Non-self-employed individuals who make $40,000 would pay 5.3% on the first $106,800 of their earnings. The total Social Security tax going towards retirement for an individual earning $40,000 per year would be $2,480. However, this amount is matched by your employer to total the same $4,960 a self-employed person would pay in.
* These numbers are based solely on the percentage taxed for the Social Security retirement trust fund, and do not include the Social Security tax you pay towards disability insurance or the Medicare payroll tax.
How Much Will You Receive in Retirement, Via Social Security Benefits?
The monthly Social Security benefit payments you receive in retirement are based on an average monthly income over the 35 years you make the most income. For instance, one individual could have had a great income run from 20 to 55 years of age, while another hit his stride at 30. The average monthly income over this time period is called an indexed income.
The amount received when we hit retirement age is then calculated using your indexed average income. Your benefit payment is also called your primary insurance amount (PIA). We'll use the formula for someone retiring in 2010 at age 65.
The PIA formula is provided by Social Security Administration spokesperson Essie Landry:
- 90% of the first $761 of his/her average indexed monthly earnings, plus
- 32% of his/her average indexed monthly earnings over $761 and through $4,586, plus
- 15% of his/her average indexed monthly earnings over $4,586.
Example: Let's say you are retiring this year with an average income of $40,000 per year in your best earning years, which is equivalent to $3,333 per month. You would get 90% of your first $761 dollars, which equals $685. You will receive 32% on the remaining $2,572 in monthly income, which equals $823. Your total monthly benefits payment would be $1,508.
The Social Security Administration provides a retirement estimator calculator for you to calculate an approximation of your future retirement benefits based on your own earnings thus far. Landry also says, you can use it to create "what if" scenarios, based on different retirement dates and future earnings/income estimates. (To learn more, see A Tour through Retirement Plans.)
Calculating Private Retirement Savings
Let's say you created your own Social Security fund using Social Security tax percentages. You could use the 5.3% you are paying as an individual working for someone else, or the 10.6% you pay as a self-employed individual. We'll assume you maintain this rate with an annual income of $40,000 and deposited into a savings or investment account on a monthly basis. We'll also assume you are 35 years of age retiring at age 67, and in this example earning 5% interest compounded monthly.
- 5.3% - With a monthly deposit of $177 per month, you'd have $167,942 at retirement. If you continued to earn 5% interest on your money, you could withdraw $700 per month without touching your principal.
- 10.6% - With a monthly deposit of $353 per month, you'd have $334,898 at retirement. If you continued to earn 5% interest on your money, you could withdraw about $1,400 per month without touching your principal.
If your money grew at an 8% interest rate, you could nearly equal your retirement principal from the 10.6% rate at the 5.3% rate.
Creating your own Social Security fund is just one way to provide income in retirement. Consider all your options, like your 401K plan where you work. Consider working towards being debt-free as part of your retirement planning, as well. Don't forget to discuss retirement planning with your spouse. A worry-free retirement is the result of solid planning and reviewing all options.