How does the Social Security cost of living adjustment work?

After 2022 saw prices rise at their fastest pace in decades, many households have been relieved to see smaller and slower increases in 2023. Even in more typical years, though, inflation can erode purchasing power for everything from gas to groceries.

The good news for older Americans: The Social Security cost of living adjustment, or COLA, can provide some relief to retirees and other recipients struggling to make ends meet. Here's a look at how and when the program calculates that increased benefit amount.

The yearly cost of living adjustment (COLA) is a provision by the Social Security Administration (SSA) to help offset higher expenses for workers who have earned and claimed their retirement benefits. The adjustment also applies to spouses and survivors receiving retirement benefits and to individuals who are disabled or blind and receive Supplemental Security Income.

The percentage increase in benefits roughly coincides with the rate of inflation throughout the economy, which helps recipients keep up with rising prices.

The tricky part about implementing a COLA is that there's no perfect measure of inflation for a particular individual or household. For its part, the SSA uses a metric called the Consumer Price Index for Urban Wage Earners and Clerical Workers. The CPI-W, as it's often abbreviated, reflects an array of expenses that workers typically face, including food, shelter, clothing and transportation.

To arrive at the cost of living adjustment, the SSA compares the average CPI-W value for the third quarter of the prior year to the average number for the third quarter of the current year. The percent increase is the Social Security COLA that applies to benefits for the following year.

There was a 3.2% jump in the CPI-W from the third quarter of 2022 to the same period in 2023. Therefore, the SSA implemented a 3.2% increase in COLA benefits starting in January 2024 (the disability COLA has a start date of Dec. 30, 2023).

With consumer price increases slowing this year, it's no surprise the 2024 COLA is considerably lower than it was for 2023.

Your Social Security benefit is based on your primary insurance amount, or PIA, which is calculated through a benefit formula based on your earnings. Your PIA is increased by the COLA, then truncated to the next lower dime.

If your initial PIA is calculated at $1,800 and is increased by the 3.2% COLA, your new PIA would be $1,857.60. If you start claiming Social Security benefits at your full retirement age (which, depending on when you were born, will be somewhere between 66 and 67), your benefit will be equal to your PIA. However, if you take benefits early (as early as age 62), your monthly benefit will be lower than the PIA. Delay receiving benefits until after you reach normal retirement age (up to age 70), and your benefit will be higher than your PIA.

If you have your Medicare premiums deducted from your monthly Social Security benefit, the change in your net payout may not equal the COLA. The adjustment only applies to the benefit itself.

For most of the past three decades, inflation has been mild, which meant the Social Security COLA was modest. For instance, during the 15-year period from 2007 to 2021, the average annual adjustment was 1.7%. In three of those years, a flat CPI-W meant no COLA was applied to benefits.

Here's a look at the annual Social Security COLA by year:

• 2005: 2.7%
• 2006: 4.1%
• 2007: 3.3%
• 2008: 2.3%
• 2009: 5.8%
• 2010: 0.0%
• 2011: 0.0%
• 2012: 3.6%
• 2013: 1.7%
• 2014: 1.5%
• 2015: 1.7%
• 2016: 0.0%
• 2017: 0.3%
• 2018: 2.0%
• 2019: 2.8%
• 2020: 1.6%
• 2021: 1.3%
• 2022: 5.9%
• 2023: 8.7%
• 2024: 3.2%

The last decade was relatively stable until a sudden jump in inflation occurred as businesses ran into supply chain issues and global oil prices surged. The 5.9% increase in 2022 represented the largest cost of living adjustment since 1982. Then, the 8.7% for 2023 topped that. The 2024 increase is only the seventh highest in the last 20 years.

A COLA increase could affect you in ways you might not expect. That's because the income threshold where Social Security benefits become taxable is not indexed to inflation.

For instance, joint filers with combined income between $32,000 and $44,000 may have to pay income tax on up to 50% of their Social Security payout. And if your combined income is more than $44,000, up to 85% of your benefit could be taxable. Combined income is calculated as taxable income plus nontaxable interest plus half your Social Security benefit.

Older adults with other income from wages, self-employment and interest are more likely to have combined incomes that make a portion of their Social Security benefits taxable. An increase in your taxable income also could mean paying more for Medicare Part B and Part D premiums.

While the COLA may sound like welcome news if you're already claiming benefits, the adjustment means you're merely maintaining the purchasing power you had the year before. Because the SSA's inflation metric of choice looks at typical expenses for workers and not retirees, some argue it may not even fully succeed in that regard.

For the majority of older Americans, those monthly benefits replace less than half of their pre-retirement earnings. Therefore, you may need other assets whose value tends to keep up with inflation.

Creating a comprehensive financial plan that protects your income from price hikes is one of the cornerstones of a secure retirement. Need help getting there? A local Thrivent financial advisor can offer time-tested financial guidance based on your unique needs.