I often ponder partial retirement. Something where I work 2-3 days a week on average for a year.
Several reasons drive this:
- If/when we have kids, that's a part of their life I want to be vitally involved in (whether we're FI or not)
- Life flexibility from working 3 days a week would be significant
- Taxes greatly, greatly, GREATLY favor someone doing this
The last reason is pretty significant. Imagining a family of 5, I want to investigate an "optimal" income strategy based on current tax code.
There are a few current tax incentives I am aware of which can amplify income. Namely, how the EITC, savers credit, and child tax credit interact with 401(k) contributions.
Child Tax CreditThis is pretty simple. Unless your household income is
more than $110k, you get $1k in
refundable credits per qualifying child.
A note, each child also reduces your federal taxable income by $4050.
EITCAccording to
this calculator you receive the following for a family of 3 based on a few amounts of earned income (assuming AGI is not higher due to Roth conversions, etc):
- $20k --> $6,241
- $24k --> $6,153
- $25k --> $5,942
- $26k --> $5,732
- $30k --> $4,890
- $35k --> $3,838
- $40k --> $2,786
- $45k --> $1,734
- $50k --> $682
A few interesting observations. First, for someone with an earned income/AGI of only $20k you get a huge EITC. Second, your benefit isn't really reduced much going to $25k income but after that the tax benefit starts dropping about $200 for every $1000 in additional income.
The "sweet" spot is $24k or so earned income. This gets complicated and I'm hoping to get clarity. My understanding is that on a normal W-2 the amount of "earned income" is Box1. This is post 401k/HSA withdrawals. So payroll deductions like 401k/HSA
do reduce your earned income (as well as AGI). The language on Box1 is identical to the
what is earned income? page from the IRS.
However, deductible IRAs only reduce AGI and not earned income. Since EITC is the lower amount of either your AGI/earned income, assuming both are under
these amounts, your earned income would stay the same.
The benefit here is that you can consequentially add a full HSA/401k contribution to the $24k sweet spot, giving your "real" income to be $24k+$18k+$6.75k = $48,750 salary. Additional income will still give you more net money, however your marginal tax rate will be about 30% (between FICA and loss of EITC).
Savers CreditThis isn't that useful for any of the above situations, because it's a nonrefundable credit. However, if you don't have children this can be worth $4,000 in federal tax refund if your AGI is within certain thresholds. Note that 401k/traditional IRAs both reduce this and so can "double" count as the percentage of your contributions you get back increase significantly as you lower AGI.
SummaryFor a family of 5 making $50k a year:
- Contribute $18,000 to a 401k
- Contribute $6,750 to a family HSA
- Have $25,250 earned income remaining
- Pay no federal income tax
- Receive about $5,900 from EITC
- Receive $3,000 in refundable child-credits
After FICA, they have $22k take-home pay plus $8900 in tax returns for a grand total of:
- $30,900 after-tax income
- $18,000 401k savings
- $6,750 HSA savings
Or in total $55.7k net worth increase. Obviously if you want to/have to earn less you can adjust the $18,000 in 401(k) contributions as desired.
What other strategies or tax incentives am I unaware of that can be used to improve this approach?