What is a Social Security COLA and how can it affect your retirement plan in 2025?

“Inflation is when you pay $15 for the $10 haircut you used to get for $5 when you had hair.” –– Former baseball player Sam Ewing

That quote is funny – and it’s also instructive because it’s pretty dated due to inflation. A recent estimate of the average cost of a men’s haircut was $28 as of last year, with another source offering a range of $20 to $40.

Savvy people understand that inflation is always with us, to varying degrees, and that it will erode the purchasing power of our dollar over time. This can be especially important for retirees. Imagine, for example, that you retire at age 62. If inflation averages 3% annually for the next 25 years until age 87 (potentially another decade of life ahead), anything that cost $100 when you were 62 will cost you about $209 by age 87 .

So if you plan now to buy a new $35,000 car in the future, it might cost you $50,000 or even $70,000. Anyone engaged in retirement planning (as we all should) should take inflation into account.

Social security and inflation

When it comes to Social Security and inflation, there is good news and bad news. For starters, Social Security protects beneficiaries from inflation—to a degree. It does this through cost of living adjustments (COLAs) that occur almost every year. Some people see these as annual “raises,” but they’re not really increases in your purchasing power. They simply increase your income in an attempt to keep up with the ever-decreasing purchasing power of the dollar.

These COLAs have averaged about 2.6% over the past two decades, but have occasionally been much higher or lower. Check out some recent Social Security COLAs:

Data source: Social Security Administration.

The next benefit increase for 2025 will be announced in October, and many expect it to be around 2.6% — close to the long-term average.

Social Security COLA and your retirement

So you can expect inflation-related increases from Social Security throughout retirement, but don’t expect them to be perfect. Because everyone’s expenses are different, each year’s COLA will provide different degrees of relief. For example, if health care costs are rising much faster than other expenses and you spend a lot In terms of health care, a COLA that is based on a wide range of price brackets will not fully offset increases in health care.

The COLA is based on the Consumer Price Index for Urban Wage and Service Workers (CPI-W), which is calculated by the Bureau of Labor Statistics based on changes in the average prices of household goods such as food, housing and transportation. Some believe this is not the best measure of inflation for retirees because it focuses on the costs borne by workers, not the spending of retirees.

A better measure for calculating COLA is the Consumer Price Index for the Elderly (CPI-E), which counts more categories like health care and housing than the CPI-W. Thus, it has been estimated that retirees typically receive a somewhat lower COLA than they should.

Consider inflation in your retirement planning

As you plan for your retirement, here are some ways to deal with inflation:

• Try to save aggressively and invest efficiently. You may want to save a lot more than 10% of your income — and you’d do well to invest a large portion of your long-term dollars in stocks, perhaps at a reduced fee. S&P 500 index fund.

• Plan somewhat conservatively, saving more than you think you need and preparing for the worst. Keep health care costs in mind as they can be substantial in retirement.

• Make the most of tax-advantaged retirement accounts like IRAs and 401(k)s. Traditional accounts offer upfront tax deductions, while Roth accounts can leave you with tax-free withdrawals in retirement. Paying less in taxes can help offset the effects of inflation.

• You don’t intend to rigidly follow a single retirement withdrawal strategy, such as the helpful but flawed 4% rule.

• Consider holding lots of shares in healthy, growing companies that pay dividends, as dividend payments are often raised regularly and can help you keep up with or beat inflation.

• Many of us would like to create multiple streams of income for our retirement. This can include Social Security, dividend income, annuity income, rental property income, possibly pension income, and so on. For some people, even a reverse mortgage might make sense.

Finally, while Social Security COLAs can be disappointing, you may want to start planning now to take steps to maximize your Social Security benefits. The bigger they are, the bigger each increase will be. For example, a 3% increase when your benefit check is $2,000 is $60 more, but a 3% increase on a $3,000 benefit is $90.

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What is a Social Security COLA and how can it affect your retirement plan in 2025? was originally published by The Motley Fool