As someone who recently joined the ranks of the FIREd, I have plenty of options for how to spend my time. It’s pretty nice! While I’m confident that our savings should be enough to see us through the rest of our lives, I fully expect to come across some opportunities to do interesting things and also earn some money on the side.
My first thought when considering the impact a small side gig might have on our finances is that the self-employment taxes will be huge, and that the amount left over might not be worth the effort. As I found out, this is not necessarily the case for a FIREd family.
Example 1: Roth conversion ladder
Consider a retired couple with two kids living at home, spending $50,000 per year. They have essentially all of their savings in retirement accounts, and use the Roth conversion ladder to access this wealth prior to age 59½.
Their federal income tax situation, in a nutshell, looks like this:*
- Adjusted Gross Income: $50,000 from Roth conversions
- Standard deduction: $24,000
- Taxable income: $26,000
- Tax before credits: $2,742
- Child tax credit: $2,742
- Total tax (before ACA credits): $0
No income tax for this family. Not bad! This family buys their health insurance through their state’s ACA exchange. With an AGI of $50,000, the second-cheapest silver plan will have annual premiums of $3,225. They pay for these premiums out of their $50,000 budget.
Now consider what might happen if one of the adults in this family starts a small part-time business, bringing in a pretty modest $15,000 per year. They use this money to help pay their living expenses, reducing their need for Roth conversions by an equal amount. This business would expose the family to self-employment tax of 15.3% on the business income, but it also opens up a few interesting tax breaks for self-employed folks.
First, self-employed people can deduct the cost of their health insurance premiums. This deduction is calculated prior to AGI, similar to the treatment that people who get health insurance through their employer get to claim.
Self-employed people also get to deduct half the cost of their self-employment tax from their AGI, similar to how employees have their employer pay half their FICA taxes and this half never enters into their own personal income tax calculations.
The tax cuts that went into effect in 2018 introduced a new deduction for business owners: the 20% qualified business income deduction. This applies to business income that is not otherwise deducted from income, so the deductible half of self-employment tax and the health insurance deduction don’t count toward the income that is used for this deduction.
Finally, the fact that this family now has some work-related income makes them potentially eligible for refundable child tax credits and the earned income credit.
Let’s see how their taxes shape up now!
- Roth conversion income: $35,000
- Business income from Schedule C: $15,000
- Gross income: $50,000
- Deduction for half of self-employment tax: $1,060
- Deduction for health insurance premiums: $2,679
- Adjusted gross income: $46,261
- Qualified business income deduction: $2,252
- Standard deduction: $24,000
- Taxable income: $20,009
- Tax before credits: $2,022
- Child tax credit: $2,022
- Regular income tax: $0
- Self-employment taxes: $2,120
- Additional child tax credit: $1,716
- Earned income credit: $1,099
- Total tax (before ACA credits): $-695
That’s right, negative $695 of tax! Far from being an expensive proposition tax-wise, this self-employment activity unlocked tax credits that more than paid for the self-employment tax. The pre-AGI deductions from self-employment also increase their ACA premium tax credit by $546. That’s a total benefit of $1,241, even before taking into account the effect that this extra $15,000 of work income will have on their eventual social security benefits.
Example 2: Spending down a taxable account
The previous example looked at a family who was going with the Roth conversion ladder for 100% of their spending. Now let’s look at a family in a situation more similar to my own, starting out in FIRE with a taxable brokerage account that they want to spend down before moving on to tax sheltered funds.
Same family size and $50,000 spending as before. This time they take the full $50,000 from a taxable account: $10,000 of dividends and $40,000 from selling shares with an average basis of half the current market value, leading to $20,000 of long-term capital gains income.
They also do $20,000 of Roth conversions to prepare for future years when they’ll be relying on seasoned Roth basis for their Roth conversion pipeline.
Tax situation before starting a small business:
- Roth conversion income: $20,000
- Qualified dividend income: $10,000
- Long-term capital gains: $20,000
- Adjusted Gross Income: $50,000
- Standard deduction: $24,000
- Taxable income: $26,000
- Tax before credits: $0
- Child tax credit: $0
- Total tax (before ACA credits): $0
Similar to the family living off Roth conversions above, the family in this example has no federal tax liability before starting their small business. Let’s see what happens afterwards with $15,000 of self-employment income.
As they’re still trying to spend down their taxable account, they keep withdrawing from their taxable savings as before, and save their full self-employment earnings in Roth retirement accounts. They reduce their Roth conversions by $15k to keep their taxable income pretty steady.
New tax situation:
- Roth conversion income: $5,000
- Business income from Schedule C: $15,000
- Qualified dividend income: $10,000
- Long-term capital gains: $20,000
- Gross income: $50,000
- Deduction for half of self-employment tax: $1,060
- Deduction for health insurance premiums: $2,679
- Adjusted gross income: $46,261
- Qualified business income deduction: $2,252
- Standard deduction: $24,000
- Taxable income: $20,009
- Tax before credits: $0
- Child tax credit: $0
- Regular income tax: $0
- Self-employment taxes: $2,120
- Additional child tax credit: $1,716
- Earned income credit: $0
- Total tax (before ACA credits): $404
In this scenario the family is ineligible for the earned income credit due to their taxable investment income. Anyone with more than $3,500 of such income is ineligible for the earned income credit. The additional child tax credit and the additional ACA credits still combine to more than annihilate the self-employment taxes.
This is a result I didn’t really expect when looking into the impact a side business would have on an early retiree’s taxes. I thought that surely the taxes would go up. In many cases, especially where kids aren’t involved, that probably would happen. But when you bring kids into the mix, tax credits meant to help low-income working families can help you too!
* All calculations in this post use tax formulas from 2018. Amounts in 2019 will differ slightly due to annual inflation adjustments in the tax code.
I love this, there’s even more detail you could go into with various analysis.
I can tell you have a good deal of tax knowledge, or at least good software to plug these scenarios into, because calculating the EIC can be a bear with SE income involved.
I’ve been running scenario analysis toying with the idea of a part-time: W-2 job earning around $15k/yr once I start Early retirement. Assuming living expenses of $50k per year as you did above, and a family of 4 (2 children under 17), this would essentially max the EIC at around $5,700 if we could keep investment income under $3,500. Additionally, I believe it would make the Child tax credit refundable up to $1,400 (tax liability is around $2,600), so you could actually get an approximately $7,000 check from the IRS.
What are your thoughts on this, I might be missing something.
In order to keep investment income that low, we would have to get pretty creative with what shares to sell and also finding low-dividend paying funds. It might be a strategy that can only be well-implemented every other year. Y1 could be tax gain harvesting additional IRA rollovers to remove excess capital gain space and utilize additional forfeited CTC space (due to no earned income) and Y2 could potentially implement this strategy – if you can find a likable, part-time, W-2 job, that is.
Thanks for your comment.
For these tax calculations I use the excellent spreadsheet at http://excel1040.com/. I assume it’s doing the math correctly for the EIC given self-employment income. If it isn’t, please let the author know! He’s happy to revise as needed.
I find that a taxable account of any significant size, invested in index funds, is basically incompatible with claiming the EIC. Total market funds like VTSAX pay out somewhere in the neighborhood of 2% dividends, meaning if you have more than $175k worth you’re running right up against the $3,500 limit before you sell a single share.
There are ways to get dividends down, but they all seem to require that you diverge from the “own the whole market” philosophy. For example Vanguard offers a “tax managed” stock index fund (VTCLX) that tracks the total market pretty well and has a marginally lower dividend yield by weighting a bit more toward non-dividend-paying stocks. You could maybe own as much as $250k of this fund without disqualifying yourself from the EIC on dividends alone.
You could diverge a bit more from the total market ideal and go with their “growth index fund” (VIGAX). That brings the yield down to around 1%, so you could potentially own as much as $350k worth, again without being able to sell any appreciated shares.
If your taxable account is below these limits I think your strategy of harvesting gains every other year so that you don’t need to in the other years could work out.
Our taxable account happens to be mostly invested in VTSAX and significantly larger than the $175k EIC limit for that fund. In order to become eligible for the EIC in the near future we would have to basically sell a large fraction of our index fund shares, pay a bunch of capital gains tax this year, and shift the proceeds into individual non-dividend-paying stocks. I don’t think that’s worth the cost in our case. Instead we’re just spending down the taxable account first, and shifting money into tax shelters like HSAs and IRAs when the opportunity presents itself. We likely won’t be eligible for the EIC for several years, if ever, and that’s okay.
Thanks for your reply!
I have the benefit of being young and not even having a taxable account open yet. There are a lot of variables that could change, but my hope at this point is to leave this option open as a potential strategy as both my wife and I are thinking we may want to do something part time even after we reach financial independence (maybe teach a class or two at a community college or something). Right now I’m projecting we’ll live on about $35-45,000/year in FI. We may be able to cover the first 5 years with just Roth contributions to fund the initial 401k rollover process, since we’ve both contributed the max to our roths for the last 3 years and are between 10-15 years from FI. The strategy of maintaining a relatively low taxable account could be accomplished by simply diverting more of our excess cash flow (going to savings for a down payment right now) into mortgage payments (once we buy a home). This could be doubly beneficial for this strategy, because it reduces total necessary spending in FI and the amount of money in the taxable account. You’re right, $3,500 could be walking on a razor’s edge, especially if the IRS doesn’t increase it for inflation.
Thanks so much for the info. on funds, I couldn’t figure out how to find low-dividend paying Vanguard funds! Also thanks for linking the spreadsheet (although work won’t let me download it). I’m in the process of trying to build my own (it’s kind-of a chop job right now), just because I already work in corporate tax and like excel. I can end up with big chunks of free time at work, so it keeps my individual tax knowledge sharp. It looks like all of the numbers are spot on to what mine calculated.
Thanks for writing geeky tax articles, I really enjoy this one and your analysis of the ACA is the best I’ve seen online.
Interesting analysis. It seems this “negative tax small business” idea relies on the child tax credit. Perhaps a better way to summarize it would be: if you have unused tax credits that require earned income to use, it makes sense to earn some income.
When I run the numbers for a FIRE couple without child tax credits and moderate taxable dividends, the 1099 income definitely creates more tax liability through SE tax plus increased ACA tax (reduced subsidy). The trick seems to be limiting income to stay below the ACA cliff (around 63k MAGI I believe).