How Does Early Retirement Affect Social Security benefits

With the Great Resignation and many individuals pursuing FIRE (Financial Independence, Retire Early), many people are leaving the workforce or following lower-paying pursuits.

You may believe these people are giving up a lot of Social Security income due to how benefits are calculated, but it’s not that bad.

That’s because Social Security payouts are regressive. When you quit your six-figure career at age 40, you may have only earned Social Security earnings for 20 years (in many cases, 15), so most of your subsequent earnings won’t boost your future benefit. If your age-40 earnings were the last that applied to your Social Security, like if you opted for volunteer work and lived off your savings, the impact on your benefits may surprise you.

Social Security uses “bend points” to calculate your Primary Insurance Amount or your Full Retirement Age benefit. 2022 bend points are $1,024 and $6,172. The first $1,024 of your indexed average lifetime earnings are weighted at 90%, amounts between $1,024 and $6,172 at 32%, and amounts exceeding $6,172 at only 15%. Log on to the Social Security website to discover how bend points affect you and how to get your Primary Insurance Amount (PIA).

When an early retiree has fewer than 35 years of earnings (for example 20 years), Social Security will still average their earnings (indexing the earlier years to your age-60 year) as if there are 35 years to calculate. In this example, 15 years are zeros, lowering your lifetime average.

Adding more years of high earnings doesn’t necessarily improve Social Security benefits because the weightings are highest at the lower end of the average earnings scale. You’re taxed at the same rate (up to the annual maximum), but your benefit doesn’t rise as much.

Here’s an example:

John, born in 1962, is 60 this year. John was ahead of the FIRE curve because he earned enough during his career to stop working altogether at 40 in 2002. John maxed out his Social Security earnings every 20 years since he hasn’t paid any tax into Social Security. His income beyond age 40 came from passive investments made with his high income earned during his 20 working years.

What if John had kept earning his high income up to this point? John’s age-67 benefit would be $3,377 if he made the maximum Social Security taxable amount for 40 years. $9,400 (30%) more per year, but John would have had to get up at 2 a.m. for 20 years to bake doughnuts.

That’s an extreme example, so let’s look at another one. John’s twin brother Jake made $40,000 each year over the same 20-year span. Jake is eligible for an FRA benefit of $2,141 if he last worked at age 40. If Jake had kept working in the same position (with no pay increases) until he was 60 in 2022, the additional years of earnings would only increase his benefit to $2,661 at age 67.

That amounts to $520 extra per month ($6,240/year), a 24 percent raise, in exchange for mopping the floor at 3 a.m. for 20 more years.

But neither of these was Jake’s actual outcome; he began his own bicycle business in his 41st year and has run it ever since. It wasn’t as lucrative as wiping doughnut shops, he made around $20,000 per year, but it helped him get by. When combined with the passive investment income that John helped Jake organize, Jake’s modest needs were met.

Jake is due a Full Retirement Age payout of $2,453 per month with this extra 20 years of income from following his passion in life – nearly as much as John earned with his very high salary over 20 years.

So, yes, retiring early affects your Social Security payment, but not as much as you think. Partial retirement, like pursuing a passion as a “new chapter,” may not affect Social Security as much as you’ve been led to believe.

If your earnings record was at the lower end of the scale, the benefit of continuing to add to your earnings record could be significant. However, the influence is less pronounced at the middle and upper-income levels.

Note: A 60-year-old was used in the examples because there are existing indexing data, bend points, and maximum earnings amounts. If a 40-year-old were used in this example, there would have to be several assumptions made about the next 20+ years. These are made-up examples to show how early retirement affects Social Security.

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