8.3 How Benefits Are Determined
Social Security benefits were computed on a worker's average monthly wage (AMW) if the person became eligible for benefits before 1979. Since 1979, the calculation has been based on the worker's average indexed monthly earnings (AIME). Both the AMW and AIME express averages of the worker's lifetime earnings subject to the FICA tax. However, the AIME takes inflation into account (called weighting).
The AIME is applied to a formula, which yields the primary insurance amount (PIA). The PIA is the amount equal to the worker's full retirement benefit at age 66 (or benefits to a disabled worker). Benefits are usually expressed as a percentage of the worker's PIA. Benefits are reduced for early retirement.
Determining Social Security benefits is totally different than the way in which unemployment benefits are determined. With unemployment, the more your salary during your last employment, the more unemployment benefits you are entitled to (up to a CAP, of course). Social Security provides a taxable wage base and no matter how much money a person makes, they pay taxes only on the wage base and nothing more. In some ways this doesn't sound fair since, proportionately, a person making less money would have a more difficult time paying the same taxes as a person who makes much more. However, the end result is the same. The richer person will be entitled to no more benefits than the other since the taxable wage base provides benefits on a proportion to total earnings basis.
FICA taxes are used for funding in two ways - Social Security (OASDI) and Medicare. Social Security is referred to as a pay-as-you-go system wherein the funds collected today are used to pay out benefits today. Any amount above and beyond the paid out benefits are kept in reserve for future payouts. It is important to note though that if the system goes defunct, there's no guarantee that just because you paid into the system, means that the benefits will be available for your future; they will be available for the future, but not necessarily your future as no individual is tied to the reserve funds.
Employers and employees alike pay an equal amount of the employees' contribution. As stated previously, the tax rate for self-employed persons in 2012 was 15.3% (the same as in 2011). Self-employed workers pay a higher rate because they not only are the employer, but the employee as well, so they must pay both shares; however, the taxable wage base remains the same. Once the annual taxable wage base has been reached, no more FICA taxes are deducted for the remainder of that year.
Since 1972, the wage base has been increased annually. Prior to 1991, the wage base was used for both OASDI and Medicare. Since then, the taxable wage base is only applicable to OASDI; Medicare continues to be taxable regardless. There is no CAP on the earnings upon which the Medicare tax is paid.
In 2012 the taxable wage base and the tax rate stayed the same as in 2011 - 6.20% OASDI and 1.45% Medicare (total 7.65%). The FICA tax rate is also subject to increases, though not as often as the wage base. Even after the $110,100 CAP is reached, however, the only portion that ceases to be taxed is the OASDI portion. The percentage allotted to Medicare is still applicable as there is no CAP on earnings for the Medicare portion.
Ralph earned $115,000 in 2012. How much would Ralph's employer deduct from his salary for FICA taxes that year?
$110,100 x .0620 = $6,826.20 (toward OASDI)
$115,000 x .0145 = $1,667.50 (toward Medicare)
$6,826.20 + $1,667.50 = $8,493.70
