How Social Security Wages Determine Your Retirement Benefits

Social Security wages include the money you earn that is subject to the Social Security portion of payroll taxes -- also known as OASDI taxes. Currently, the withholding rate is 6.2% of the earnings, up to the Social Security earnings cap, or wage base, for both the employer and the employee. This amount changes over time to keep up with inflation, so here's a primer on Social Security wages and how they affect your retirement benefits.

The Social Security wage base

Each year, there is a maximum amount of earnings that are subject to Social Security's Old-Age, Survivors, and Disability Insurance (OASDI) taxes. This amount is known as the Social Security wage base, or the contribution and benefit base.

For 2016, the contribution and benefit base is $118,500, and the Social Security tax rate is 6.2% for both the employer and employee. In other words, the maximum amount of Social Security tax an individual will have to pay in 2016 is $7,347, no matter how much they earn. Self-employed individuals pay both sides of the OASDI tax, or an overall rate of 12.4%.

Just to give you an idea of how the wage base has risen with inflation over time, here's a recent history of the maximum earnings subject to Social Security tax:

Data source: Social Security Administration. A complete history is available on the SSA's website.

How the maximum Social Security wages determines your Social Security benefit

Your Social Security benefit depends on an inflation-indexed history of the top 35 years of your earnings, up to the annual maximums I discussed earlier. So, the first point to realize is that the contributions and benefit base only factors into your benefit if your earnings were greater than the maximum in any year.

To determine your career average earnings, here's the procedure to follow. First, write down your earnings for each year, and next to each year's earnings, write down the maximum taxable amount for that year. For example, if you earned $70,000 in 2000, you'll notice that the maximum for that year was $76,200, according to the chart.

Then, multiply the lesser of the two amounts by the annual index, which is 1.45 for 2000, according to the SSA. So, for 2000, your indexed earnings would be $101,500. You can find the index multipliers for all years in this worksheet.

Repeat this procedure for every year in which you had earned income, and cross out all but the top 35. Finally, add all of these annual amounts together, and then divide by 420 -- the number of months in 35 years. This is the monthly average earnings on which your Social Security benefit will be based.

Once your indexed monthly earnings have been determined, a formula is applied to calculate your monthly retirement benefit. As of 2016, this formula is:

• 90% of the first $856
• 32% of the amount greater than $856 but less than or equal to $5,157
• 15% of the amount over $5,157

An example

Let's say you index your earnings according to the Social Security Administration's procedure and determine that your monthly indexed average is $4,000. We can calculate your Social Security retirement benefit as follows:

The future of Social Security wages

Having said all of that, there's a possibility the Social Security wage base will change dramatically in the not-too-distant future. The Social Security trust funds are projected to run out of money by 2034, and one of the potential ways to increase the flow of money into the system would be to raise, or even eliminate, the maximum amount of taxable earnings.

If that were to happen, the maximum benefit would likely rise as well, but this is definitely something to be aware of as far as your taxes go, especially if you're a higher-income individual.

The article How Social Security Wages Determine Your Retirement Benefits originally appeared on Fool.com.

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