The Lovely Low Taxes of Early Retirement

A sand island at the local lake, part of a recent “workday” with my boy.

Despite the occasional complaints voiced by those who feel they are Taxed Enough Already, I’m always pleasantly surprised at the low tax rates that US residents pay (myself included).

I guess it all depends on your frame of reference: the Canada that I left in the late 1990s had a marginal income tax rate of about 50% at the time, which kicked in at an income of about $60,000. I had almost reached the top tax bracket just two years out of school, which I found was a disincentive against going on to earn a much higher income. Since then, Canada’s tax rates have dropped drastically, leaving them much more competitive with the US.

But for this article, let’s see exactly how good or bad the situation really is, using the Money Mustache family as a case study.

Looking at my recently-filed tax documents, it looks like we had about $72,000 of income for the 2011 tax year. That’s a mix of the rental house income, dividends, a few carpentry projects for me, a bit too much part-time work for Mrs. MM as she helped some people through an unexpected crunch, a bit of blog income and some capital gains. It was an unexpectedly flush year, and we’ll do our best to earn less in 2012, lest the Internet Retirement Police start hassling us again about being “not really retired”.

Countering this rather large income was the $1000 child tax credit, tuition credits for little MM’s preschool, and of course the wonderful $11,600 standard deduction for two people married filing jointly.

When you add it all up, our Federal taxes (including social security and medicare) were $4884, with an additional $2211 of State tax for Colorado. So $7095, or just under 10% of the income went to the tax man.

That’s pretty reasonable, considering that it was such a bumper year of income. I’ve got Turbo Tax open in the other window right now, so let’s see what happens if I delete all the extra income and keep only enough to pay for our regular spending of $27,000. To provide a nice safety margin, I’ll scale everything so it adds up to about $30 grand. Here’s how I’ve got it split up:

Wages and Salaries: $19,000
Taxable Interest: $59
Ordinary Dividends: $373
Capital Gains: $5190
Business Income (Schedule K-1): $5501

Total:  $30,123

Now let’s pull the lever and see exactly what we would owe on this level of income:

Federal Tax: $654 (mostly self-employment tax)
… then subtract the $1000 Child Tax Credit to get:

Net Federal Tax: -346
Net Colorado Tax: $208

Total tax: Negative One Hundred and Thirty Eight Dollars.

Wow. That’s a pretty affordable tax bill, considering it’s on over $30,000 of income, still a relative shitload compared to what one needs to live a happy life in this country!

This is of course an arbitrary income mix caused by me hastily deleting things at random from my own tax return. But at least I have some wage, dividend, capital gains, real estate and business income like a normal early retiree might have. Let’s change it again to see what the situation would be for someone living entirely off of dividends:

Dividend Income: $30,123

Running it through Turbotax again, I get….

Federal Tax $0 (but apparently lazy people with no regular income do not get the $1000 Child Tax Credit, so no refund this time)
Net Federal Tax: $0
Net Colorado Tax: $322

Total tax: $322

This is an interesting result: the first case of regular income, even with the dreaded 13.3% “self-employment tax” comprised of medicare and social security contributions, is actually more tax-efficient than the dividend earner’s setup.

People using rental real estate as their source of passive retirement income will have it even better: The depreciation allowance effectively shields 30-50% of your rental income from taxes during the early years of owning a rental property. This benefit slowly fades away over a 30-year period and only then will you pay full income taxes on the rental income. I’m getting this benefit on my own tax return, but I excluded its effects from this article, to avoid confusing the issue and to allow an apples-to-apples comparison.

But in any of the above cases, the income taxes paid by a family like mine living  on a retirement-level income are still approximately zero. This is why I rarely mention taxes when calculating things like the safe withdrawal rate. The unfortunate folks who do their retirement planning with the “you’ll need 90% of your peak career income to sustain you in retirement” financial advisers will indeed need to plan for taxes. But we Mustachians will fortunately slip nicely under Uncle Sam’s radar.

Of course, many of us will accidentally earn more than we need even in retirement, and we’ll end up paying thousands in taxes each year because of it, just like I did this year. That’s a happy compromise as well, as long as you’re not an anti-tax activist. I’m aware that I’m using the many resources provided by this country, so I don’t mind paying taxes for them. But since my entire lifestyle fits within the Zero tax bracket, I am only paying tax on the surplus income.

That makes me feel like the whole situation is entirely under my control. I can continue the current course, which works well for me. If I later decide I hate the government, I can strategically earn less money so I pay negative taxes as described above.

If I still like earning lots of money in order to maximize my power to do good in the world, but insist on paying no income taxes, I can even structure my work into the form of a charitable trust or nonprofit. This entity would pay me just enough money to get by without paying taxes, and it would donate 100% of its remaining income, tax-free, to scholarships for underprivileged kids, or schools and health care for African villages, or even Face Punching machines to be installed in shopping mall parking lots.

The world becomes a blank slate to be used for your own enjoyment. It’s  just another example of the freedom you get in early retirement. And it’s just another example of why I don’t accept complaints about taxes around here*. Save your money, build your ‘stash, and then the ball is entirely in your court .. for life!

* politically-charged complaint attempts deleted from the comments section of this article so far: 18