Retiring will lower your tax bill. You may be able to retire earlier than you think because your tax liability drops off a cliff when your earned income drops. You know how I feel about beating the taxman.

Take a look at my friend over at ESI Money as an example. He retired in his 50’s after realizing that he had enough money to retire. A benefit to not working is that his tax liability dropped big. You can see his exchange with his CPA which gives some insight as to how this works.

Lower Earned Income Tax Bracket Lowers Your Investment Income Bracket

Your capital gains and dividend income rates drop as your total income falls. It just so happens that your investment income (what I’ll call long term capital gains and dividend income here) tax rates fall at the exact same time you’ll most likely need the money in retirement.

Here are the important tax numbers for 2017 (due April 16, 2018). Scroll to the right to see the dividend and long term capital gains rates.

Here’s an example of a high-income working couple:

Let’s say you and your spouse are set to make a combined $380,000 total income in 2017 ($300,00 in earned income and $80,000 in investment income). Your marginal tax rate (when people say, “I’m in the XX% bracket”) is 33% on the federal side and then you have to add in whatever your state income tax would be.

A person in the 33% tax bracket would pay 15% on dividend income and long term capital gains. 15% is great compared to the marginal tax rate of 33%, but it’s not zero.

Assuming this person has a $1,000,000 portfolio that generates $40,000 in income results in taxes due of $6,000. Now let’s assume this person also has an additional $40,000 in capital gains for a total of $12,000 in taxes due for the year on investment income.

That means of their $80,000 in investment income, they get to keep $68,000. This is still a pretty favorable tax rate.

Now let’s look at what they pay in federal, state, payroll taxes, etc. A couple with a combined salary (earned income) of $300,000 would have to pay about $77,000 in federal tax (rough estimate including exemptions and standard deduction). State taxes vary greatly. Let’s assume this couple will pay $15,000 in state taxes. FICA would clock in at $19,461 (7.65% x the max income threshold of $127,200 per person).

Total estimated tax liability for this couple in 2017 is $123,461

They’re netting $256,537 ($380,000 – $123,461) all in on earned income and portfolio income.

They paid more in taxes than 2x the median American household makes in gross income annually.

Here’s an example of the same couple but now they’re retired:

Now let’s see what they’d pay if they hung it up – ya know, quit the daily grind.

Let’s assume they’re in their early 50’s so not yet eligible for Social Security. Remember this couple has a portfolio of $1,000,000.

Let’s also assume this couple continues to make some sort of money by doing what they love, either in a consulting capacity or by starting a small business. After all, people don’t stop working in retirement; they just allocate their time to what they want to do.

This couple loves to rehab and  invest in real estate. That’s their hobby and their side hustle. They work part time doing this. They generate $30,000 in actual taxable income, however their cash flow is higher.

If this couple would have retired instead of kept their jobs, they would have made combined $110,000 total income ($30,000 earned income and $80,000 investment income). Their marginal tax bracket is 25%.

This couple would pay zero tax on their investment income up to $75,900 total income. Because they make some earned income, we have to do some adjusting and figure in the standard deduction and exemptions. They’ll have to pay 15% capital gains tax on 10,000 of investment income and 0% on the $70,000 (estimated).

That means of their $80,000 in investment income, they get to keep $78,500. That’s an effective investment income tax rate of 1.875%!

Now let’s look at what they pay in federal, state, payroll taxes, etc. A couple with a combined salary of $30,000 would have to pay less than $1,000 in federal tax (rough estimate including exemptions and standard deduction). For our purposes, let’s say federal tax liability is $500. State taxes vary greatly. Let’s assume this couple will pay $100 in state taxes. FICA would clock in at $4,590 (7.65% x 2 x $30,000) because our couple has to pay the self-employed rate which is twice that of a regular W2 employee. Some types of income are exempt from the self-employed FICA; not the income our hypothetical couple earns.

Total estimated tax liability for this retired couple in 2017 is $6,690.

They’re netting $103,310 ($110,000 – $6,690) all in on earned income and portfolio income. This hypothetical retired couple saved over $115,000 in total taxes paid (fed, state, payroll taxes) compared to the high-income earners.

earned income

Conclusion

We made a lot of assumptions here. Some of them may seem a little too rosey. But it’s done to drive a point home: you can save a ton of dough when your earned income drops.

Some of you may feel as though you need to keep working until you claim Social Security. Remember that you will save a ton of dough when your earned income drops. You may not need to work as hard or as much as you think.

I’m a big fan of structuring your income in retirement. Trying to get the majority of your investment income into the 0% tax bracket is a smart move. You may not be able to do this. There are other ways to offset your earned income like using tax-loss harvesting and shifting to passive income. If you have a lot of investment income, you could move some of your portfolio to muni bonds to save even more in retirement. There are a bunch of ways to reduce your tax liability.

It’s very possible to keep your total income in the 15% bracket in early retirement while earning investment income that’s taxed at 0%!

Are you thinking of retiring but not sure if it’s possible? Are you newly retired and finding that it was either financially easier or more difficult? I’d like to know. Input your email below and reply to my introductory email with your questions or situation.