WHAT ARE Covered Earnings
Covered earnings refers to the total amount of an employee's pay that counts toward the calculation of retirement benefits. Generally, the bulk of covered earnings comes from an employee's base pay although occasionally other types of compensation factor in as well.
In the U.S., the Social Security Administration uses covered earnings to determine Social Security benefits. Covered earnings also determines the amount of social security taxes individuals pay prior to retirement.
BREAKING DOWN Covered Earnings
Covered earnings typically includes most types of wage income and any self-employment income. Some exceptions include earnings from certain state and local governments, as well as from railroads. Retirement benefits, whether from Social Security or pension plans, depend on workers’ earnings for a specific number of years, as well as the total amount paid towards the retirement plan over that span.
Why Covered Earnings Matter
Covered earnings come into play when workers are trying to figure out when to retire and receive the maximum benefits, either from Social Security or a pension.
For instance, covered earnings for Social Security purposes leverages a formula that uses 35 years of earnings, each indexed to a particular year. Knowing the formula is far less important than knowing any benefits depend on the last 35 years an employee worked, even if that work took place after retirement or after claiming benefits. It’s also important to know only earnings up to a certain annual cap count toward any future benefits. As of 2018, this cap stood at $128,400.
In some cases, working an additional year adds to a retiree’s covered earnings, and thus, total benefits received, provided that the amount of income in that additional year is higher than the lowest-earning year during the 35-year measurement period.
Conversely, working an extra year, but at a significantly reduced wage, hurts covered earnings if the amount received is less than the lowest-earnings year during the measurement period.
One group for which delaying retirement usually helps are those with a prolonged period of unemployment, even if that happened decades ago. For these individuals, a few extra years of full employment boosts their covered earnings.
Mistakes in a person’s work history also affect covered earnings, as under-reporting just a few years might skew eligible benefits. For this reason, the Social Security Administration suggests that, prior to retirement, individuals open a free account on its website to check their earnings history. Individuals can open the account many years before retirement, so they can periodically verify all the information gathered to be sure their covered earnings are up-to-date.