• They file taxes as married filing jointly with no dependents
• Each individual earns a full-time equivalent of $90,000/year
• Taxable investments create $12,000 per year of qualified dividends
• Taxable savings create $1,200 a year in interest
• While working, each spouse may contribute to a 401(k). Neither is over 50 so not eligible for a $6,500 catch-up contribution.
• Health insurance is provided through one employer
• The couple is not eligible to contribute to an HSA
• Taxes are based on the 2020 tax code
In our first scenario, both spouses are working full-time. Total earned income is $180,000. Total taxable income with investments is $193,200.
The maximum contribution to a 401(k) account is $19,500 per person. Since both partners are working, the couple’s total contribution is $39,000, which lowers adjusted gross income (AGI) to $154,200.
Subtract the standard deduction of $24,800 to arrive at a taxable income of $129,400. Subtracting the $12,000 of qualified dividends gives $117,400 of income taxable at ordinary income tax rates.
The first $19,750 is taxed at 10% for $1,975. The next $60,500 is taxed at 12% for $7,260. The final $37,150 is taxed at 22% for $8,173. The total is $17,408.
Qualified dividends are taxed at 15% for married couples earning between $80,000 and $496,600. The dividends generate an additional $1,800 of taxes.
The total federal income tax paid by this couple is $19,208 on $193,200 of total income. Their effective tax rate is 9.9%.
The impact of cutting back work
The second scenario reflects the impact of one earner cutting back hours. After the birth of our daughter, my wife cut back to 30 hours per week.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%.
Read:This first year of early retirement has been one of the hardest of my life
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.
