Should you retire, while your spouse continues to work?

This can make good financial sense (but maybe not so much, in psychological terms; apologies for any marital stress this post may cause).

You’ve heard of the marriage tax penalty; but you will be shocked to learn how steep it can be. When that penalty is large enough, it costs the family only a small amount if the low-earning spouse stops working.

That criterion will be met when:

1. The low-earning spouse makes less than half as much;
2. The high-earning spouse makes over $250,000
3. The family’s retirement savings are in good shape, in part because they have been seizing every opportunity to sock away money in tax sheltered accounts.
4. And, the low-earning spouse is old enough to give up the identity crutch of paid employment (I reached that stage about age 60).

Hah! Just lost my audience in Kansas and Mississippi.  Not many couples in the middle of the country make > $300,000.  But on the West coast and in the Northeast, there are millions.  That’s my audience for this post.

Here is an example.  Spouse #1 earns $250,000, spouse #2 earns $88,000.  They live in California. They pay Alternative Minimum Tax (key to what follows, but a status widely shared among couples on either Coast who make between $200,000 and $500,000).

As the calculations below show, last year, when working, spouse #2 contributed surprisingly little to family free cash flow.

Income for low-earning spouse:	$88,000
1. FICA and SDI taxes: -7.65% FICA -0.9% Medicare extra tax -0.9% CA SDI tax = 9.45% total	($  8,316)
2. Max 401(k) contribution (deductible)	($24,000)
3. Federal tax @35%	($22,400)
4. CA tax @ 9.3% (not deductible under AMT)	($  5,952)
5. Commuting, clothing & other costs of paid employment	($  4,000)
6. Free cash flow	$23,332

 

Explanatory notes (keyed to row numbers)

1. FICA and SDI are “first dollar” taxes not reduced by 401(k) contributions. Many people know they pay FICA of over 7%, but few remember to include the extra Medicare tax on earnings over $250,000, or remember California’s Short Term Disability Income tax, and its equivalent in other states.
2. The numbers are not so stark if the low-earning spouse is not contributing to a 401(k) or equivalent; and the entire scenario becomes unrealistic, if the family could not forego making these annual contributions because retirement savings were inadequate.
3. Here is where ignorance about the AMT blinds many people to the feasibility of early retirement. You probably thought the AMT rate was 28%; you’ve read so many times.  But if your income is less than $500,000 and more than $250,000—my target audience here—your AMT exemption is phased out all through that range, at 25 cents on each additional dollar earned. So the effective AMT marginal rate in this range is 28% + (28% * .25), or 35%.
4. Doesn’t matter if you itemize or not; state income taxes are not deductible against the AMT. The full rate is levied against every dollar of the low-earning spouse’s income.
5. Commuting & clothing expenses are the only arbitrary amount in the table. They can’t be zero, but may be higher or lower than the stated amount in individual cases.

Conclusion

In the example, about 75% of the low-earning spouse’s income wasn’t available to spend.  Hence, to retire would only decrease family free cash flow by about $23,000.

Not every American family could decrease spending by $23,000 a year at the drop of a hat.  But we are not talking every family; the target audience has been dual income professional couples earning $250,000 to $500,000.  An additional expectation has been that the average age of the couple is nearing 60.  Any of the following circumstances, not uncharacteristic of that age bracket, would make it relatively easy to tighten the belt by that much.

1. College tuition bills have stopped
2. The family had been prepaying mortgage principal.
3. The family had been saving or investing the free cash flow
4. The spouse who continues to work also continues to get annual raises, and / or is still climbing the career ladder

But again, the low income spouse has to be mentally ready to retire.

Footnote: Roth accounts make the numbers starker

If the low-earning spouse had been making Roth 401(k) contributions—foolish in this tax bracket, but many people behave foolishly around taxes—then the free cash flow given up would be lower yet.  Explanation: Roth contributions are not deductible.  Hence, taxes would be higher by ($24,000 * 44.3%), or about $10,600, further reducing free cash flow to $12,700 or so.  That’s all the immediate spending power conferred by the low-earning spouse’s salary of $88,000, once the tabled scenario is amended to reflect Roth contributions.