By Chris Mamula
Cutting back one spouse’s earnings by 25% reduces the household pretax income by 12.5%. But that income would have been taxed at the highest marginal tax rate, so what does this do to after-tax income?
The couple’s total earned income in this scenario is reduced to $157,500. Total income with investments is $170,700. Subtracting $39,000 for 401(k) contributions lowers AGI to $131,700.
Subtracting the standard deduction of $24,800 leaves $106,900 of taxable income. After subtracting the $12,000 in qualified dividends, it leaves $94,900 taxed as ordinary income.
The first $19,750 is again taxed at 10% for $1,975. Then next $60,500 is taxed at 12% for $7,260. Only $14,650 is now taxed at their marginal rate of 22% for $3,223. The total is $12,458.
The qualified dividends are again taxed at 15% for an additional $1,800 of taxes.
Their total federal income tax owed is $14,258 on $170,700. Their effective tax rate drops to 8.3%.
The impact of one spouse retiring
The third scenario reflects the impact of the full-time spouse retiring fully and the other spouse continuing to work 30 hours a week. This is what happened when I left my career in 2017. When married filing jointly, you can obtain a similar outcome if each partner worked 15 hours per week.
Total earned income in this scenario is $67,500. Adding in investment income brings it to $80,700. Since only one spouse is working, they can only contribute $19,500 to a 401(k), lowering AGI to $61,200.
Subtracting the standard deduction of $24,800 leaves $36,400 taxable income. After subtracting the $12,000 in qualified dividends, it leaves $24,400 taxed as ordinary income.
The first $19,750 is again taxed at 10% for $1,975. Only $4,650 is taxed at the lower marginal rate of 12% for $558. The total is $2,533.
Qualified dividends are taxed at a rate of 0% for couples married filing jointly if taxable income falls below $80,000. Thus no tax is owed on this $12,000 of investment income.
The total federal income tax in this semi-retired scenario is $2,533 on $80,700 of total income. The effective tax rate is 3.1%.
The tax code is much friendlier to low earners
Semi-retirement allows you to earn a substantial amount of income and pay little in federal income taxes. You keep about seven cents more of every dollar you earn when compared to working full-time, everything else being equal.
Semi-retirement also provides more time for your investments to grow. During this time, you eliminate tax drag on qualified dividends and long-term capital gains.
The 0% long-term capital gains rate provides the opportunity to harvest capital gains , meaning more of your future income could be tax-free with good planning.
Creating this apples-to-apples scenario is great for comparison. But life can sometimes be messier.
What about kids?
Kids don’t affect the calculations. They simply provide a $2,000-per-child tax credit .
Just multiply $2,000 by the number of children you have. Then subtract that number from the tax you calculated to get your final tax cost.
What about IRAs and Roth IRAs?
The ability to contribute to Roth IRA accounts and the ability to deduct traditional IRA accounts are dependent on your income in a given year. I couldn’t keep these variables constant for a fair apples-to-apples comparison.
Also, tax deductions are always more valuable when in the highest marginal tax rates. Roth IRAs are always more valuable for those with low enough income that they don’t pay federal income tax. In between, there is a gray area that is highly dependent on your personal situation .
What about health care?
Before I dove into the numbers on Affordable Care Act (ACA) subsidies , I thought the biggest drawback to semi-retirement was that having earned income would make health insurance unaffordable.
Our MAGI (modified adjusted gross income) last year was $73,000. Plugging that number into the Kaiser Family Foundation Health Insurance Marketplace Calculator with our specific geographic location and family demographics (two adults and one child) reveals that we would receive a subsidy of $725 per month and pay $595 a month for a silver plan through the ACA.
This is more than we pay to purchase insurance through my wife’s employer. But it is still reasonable.
Because we weren’t buying insurance through the ACA, we did nothing to optimize our MAGI. We could have contributed about $15,000 more to my wife’s 401(k) and contributed $12,000 to traditional rather than Roth IRAs.
Lowering our MAGI by $27,000, from $73,000 to $46,000, would drastically increase our subsidy and lower our premium costs. We would pay only $270 a month while receiving $1,050 per month in subsidies.
The author adds: A reader, Mister DS, pointed out an error in the comments. Deductions for traditional IRA are added back to AGI when calculating MAGI. Thus the correct calculation would be based on a MAGI of $58,000. Insurance premiums would cost $425/month with a subsidy of $890/month.
We could then meet our spending needs by selling off investments with long-term capital gains which would be taxed at 0%. However, the capital gains do count toward MAGI.
Chris Mamula retired from a career as a physical therapist at age 41. This is abridged from “The Amazing Tax Benefits of Semi-Retirement,” and you can read the full version on the blog “Can I Retire Yet?”