How Social Security annual increases are calculated

COLA formula was established by law in 1972.

Some topics are a lot more controversial than others. But I was amazed when my October 1, 2014, article that correctly predicted next year’s 1.7% cost-of-living adjustment for Social Security benefits several weeks before the official announcement triggered more than 80 vehement responses.

Most of the posts on the Investment News website reflected strong political views and general distaste for Congress and President Barack Obama. Many expressed outrage that the average Social Security benefit increase of about $22 per month in 2015 is far too low for seniors facing growing expenses, including ever-higher medical costs.

I appreciate the outpouring of opinions, but I thought I needed to set the record straight. Don’t blame the politicians for manipulating the benefit increase. Annual COLA adjustments were established by law in 1972 and begun in 1975.

To determine annual Social Security benefit increases, average inflation for the third quarter of the current year as measured by the Consumer Price Index for Urban Wage Earners (CPI-W) is compared to the average third quarter CPI-W of the previous year. The index is compiled by the Labor Department’s Bureau of Labor Statistics.

The resulting percentage increase, if any, represents the percentage that will be used to increase Social Security benefits for the following year. If there is no measurable inflation, there is no COLA.

Over the past five years, inflation has been growing so slowly that the annual increase has averaged only 1.4 % per year since 2010, less than half of the 3% average during the prior decade. In 2010 and 2011, benefits didn’t increase at all, following a 5.8% hike in 2009.

Congress enacted the COLA provision as part of the 1972 Social Security amendments. Prior to that, increases in Social Security benefits had to be approved by Congress on a case-by-case basis.

At the time of enactment, inflation was relatively high. So the provision enacted in 1972 provided for an automatic COLA only if the increase in the CPI-W was at least 3%. By the mid-1980s, inflation began to wane. In 1986, Congress enacted legislation to eliminate the 3% trigger.

The latest 1.7% COLA will begin with the benefits that 58 million Social Security beneficiaries receive in January 2015. The average benefit for all retired workers will increase to 1,328 a month, from $1,306 per month. The average benefit for a retired couple will increase to $2,176 per month in 2015, from $2,140 per month this year.

The standard Medicare Part B premiums, which are normally deducted from Social Security benefits, remain unchanged in 2015 at $104.90 per month. That means most retirees will see a net increase in their Social Security benefits next year. The same is true for higher-income people, who pay higher Medicare Part B premiums.

Benefits are not the only aspect of Social Security affected by the COLA. The maximum amount of earnings subject to the Social Security tax will increase to $118,500 in 2015, from $117,000 this year. Of the estimated 168 million workers who will pay Social Security taxes in 2015, about 10 million will pay higher taxes because of the increase in the taxable maximum.

Both employers and employees pay a 7.65% tax on wages to fund Social Security and Medicare. Self-employed individuals pay taxes as both employer and employee.
The Social Security portion of the tax is 6.20% on earnings up to the applicable taxable maximum amount. The Medicare portion is 1.45% on all earnings. Individuals with earned income of more than $200,000 ($250,000 for married couples filing jointly) pay an additional 0.9% in Medicare taxes.

The retirement earnings test amounts will also change in 2015 as a result of the COLA. Workers who collect Social Security benefits before their full retirement age (currently 66 for anyone born from 1943 through 1954) and who continue to work, forfeit $1 in benefits for every $2 earned over $15,480 in 2014. That amount will increase to $15,720 in 2015.

A more generous earnings cap applies in the year you reach full retirement age. In the months leading up to your 66th birthday, you would forfeit $1 in benefits for every $3 earned over $41,400 in 2014. That amount increases to $41,880 next year.

The earnings cap disappears once you reach your full retirement age, meaning you can collect Social Security benefits and continue to work with no impact on your benefits.

(Questions about Social Security? Find the answers in my e-book at Maximizing Social Security Retirement Benefits.)