The Power of a Low Income in Early Retirement

If I close my eyes and picture the images I associate with “retirement,” there’s still a big part of me — despite all the schooling in frugality and the general tenets of the personal finance blogosphere — that immediately goes to the stereotypical “good life.” Being able to travel in style, living in a spacious home, golfing whenever you want, checking in with the financial advisor to see how that big nest egg is doing… (In my imagination, this vision of “retirement” probably looks exactly like a Fidelity ad. Or maybe one for an active senior living community. The power of marketing!) 

And while there’s nothing wrong with those images, the more we’ve come to learn about every aspect of early retirement, the more we’ve realized that our goal should be not the good life, but the low income life, at least until we hit traditional retirement age.

This isn’t a post about saving less (you know we’d always err on the side of over-saving rather than under-saving). It’s a post about the under-recognized benefits of spending less in retirement. Because the less you spend, the less you have to earn from all of those passive sources you’re busily saving now.

And the less you can earn, the more benefits you accrue. Both warm and fuzzy benefits, and cold hard cash benefits.

Think of it as a philosophical thought-starter to assess how much you really want to spend in retirement… and what you can gain when you bring that number down, maybe way way down. Let’s take a closer look.

Income Vs. Cash Flow

Income in retirement doesn’t necessarily equal cash flow, or what you have to spend in retirement. As we broke out in this post on optimizing our income for Affordable Care Act (ACA) coverage , many early retirees will have more actual cash flow each year than their income figures will suggest. That’s largely thanks to cost basis, meaning the price you paid for stocks in the first place won’t count against you as income when you later sell those same shares. The same idea applies to rental and business income. Two examples:

Stock example

• If you bought a share for $100, and it’s worth $150 when you sell it, your “income” is $50 but your cash flow is $150.

Rental income example

• If you take in $1000 in rent, but have depreciation and expenses that total $400, your “income” will be $600 and your cash flow may be $700 or $800. (Depreciation is the best thing ever.)

This post discusses income, not cash flow. We’re interested more specifically in the definitions of income used by the IRS: taxable income (relevant for how much tax you’ll pay), and MAGI (modified adjusted gross income, relevant for how much health care will cost you). At times we’ll group both together and shorthand them as just “income.” But the overall principle remains the same: there are big benefits to keeping your income low in early retirement, much of which is within your control.

Let’s get one important caveat out of the way first: we don’t always have total control over what our income in retirement is. Stocks could have a banner year and kick out record dividends that we must count as income even if we reinvest them. We could be forced to exercise company stock options upon leaving a job. We could inherit assets that are taxable. Those are all cases where we can’t control our income exactly, but those scenarios are also rare.

Most of the time, and for most sources of retirement income — capital gains, rental income and employment income — we can engineer our income to fit within certain parameters. When we engineer those numbers to keep our income small in retirement, made possible by keeping our spending small, we stand to gain a lot.

(Usual and obligatory caveat: this is not financial or tax advice. Consult your own tax attorney to make decisions relevant to your own situation. We are not liable for any financial decisions you may make based on this non-expert blog. You’re a grown-up. You know the deal.) 

Ways a Low Income Makes You More Powerful in Retirement

ACA Premium Insulation — Starting with the biggie. There has been a lot of bellyaching lately about rising Obamacare premiums, and even claims that the system is “failing” (experts say this is debatable). And it’s true that premiums are rising a lot for higher income individuals and families. But, what hasn’t been reported is that subsidized premiums aren’t changing significantly for low-income people. Why? Because the Affordable Care Act caps premiums at a small percentage of income:

Year to year, the percent change in premiums for people under 400% of the federal poverty line is only a few hundredths of one percent, not the 20-40% or more increases that people over that limit are looking at for 2017. (400% of FPL is currently $97,000 for a family of four, and less for smaller households. Here is a breakdown.) The law also caps out-of-pocket maximum costs for lower income people, so having a low income in retirement both ensures that you’ll pay a low cost for the insurance itself, and that your total for all copays, coinsurance and deductibles will also stay in a reasonable and predictable range:

This page at the Kaiser Family Foundation has the charts above and tons of other helpful info about the ACA, unlike a lot of the other resources out there that purport to help but are either trying to sell you alternate insurance or trying to get you involved in the politics of it all. If, like us, you really just want to make sure your health needs are covered, and you recognize that this is the current law of the land, other great resources include:

• Kaiser Family Foundation subsidy calculator
• Healthcare.gov subsidy calculator (with links to state exchanges, where applicable)
• Our post on optimizing our retirement income for the ACA

And for those who don’t believe our leaders matter, there is perhaps no starker contradiction of that than the differences between states that did and did not expand Medicaid to cover adults up to 100% of the federal poverty level. In a non-expansion state, adults who are extremely poor by any definition may be unable to get any health insurance, and middle income families may not be able to get subsidies, while states that expanded Medicaid are able to offer their residents the health coverage they need and can afford. This is a good breakdown by income tier, if you’re curious.

Lower Tax Liability — While we like most of the things that taxes pay for (hooray for schools and roads!) and aren’t generally trying to get out of paying taxes, we know that a lot of early retirees count tax minimization as a core planning strategy. And nothing reduces your taxes like keeping your income low. This post from Go Curry Cracker provides an excellent overview of tax avoidance strategies you may choose to employ, should that strike your fancy.

Portfolio Conservation — My personal favorite. The thought that keeps me up at night — and probably a lot of you, too — is the fear of outliving our portfolio. Or, since we have a lot of money socked away for our later years, the fear of our “phase 1” portfolio not lasting us all the way to age 60. But there’s a solution to that: spending less than what we can afford to spend, which requires earning less each year than we plan to earn, meaning we sell fewer shares than we’d planned to sell. If we have $X budgeted in a given year, spending $.9X or even $.8X will hugely increase our likelihood of success and will allow us to keep more of our assets in stocks where they can keep growing for longer.

Making You Resourceful — Besides the obvious financial benefits of keeping your spending and therefore income low in retirement, the warm, fuzzy benefits are very much worth thinking about as well. Having less cash at your disposal means having to get resourceful. Think: MacGyver. And you know who has awesome self-esteem because he knows he can handle anything? MacGyver. Trusting yourself to figure things out even when the going gets tough is priceless, and when there’s more money handy, it’s all too easy to pay someone else to fix the problem when things get sticky.

Now that we’ve run through the benefits, let’s talk about some steps you can take to keep your income low in retirement.

Changes You Can Make Now to Keep Income Low in Retirement

Structure Your Income for Passive — Where your cash flow comes from in retirement will have a big impact on what your taxable income is, which goes directly to what your tax and health insurance situation will be. And keep in mind that most retirees will not get itemized deductions anymore (which don’t get subtracted from MAGI anyway), but instead will take a standard deduction — so you can’t bring your taxable income number down, for example, by giving a bunch to charity. Here’s a rough guide:

Dividends, “regular job” and contract work all count nearly 100% as income for the sake of ACA and tax calculations. But selling stocks counts only the gains as income (and the long-term gains are taxed at a lower rate), and with rental income, you get to slice a whole bunch of stuff out of that income, including depreciation and expenses, because rental income is reported on a separate tax schedule. So from an ACA perspective especially, capital gains and rental income are better friends in terms of how much cash flow you get out of a set amount of “income” than are dividends and traditional income.

Prepare to Stop Reinvesting Your Dividends — If dividends are counting against you in your MAGI and taxable income (they are!), then use them as part of your cash flow in retirement rather than reinvesting them. Just make sure you factor in smaller growth moving forward, as most historical growth projections assume you are reinvesting your dividends. This may require rerunning your numbers before you pull the ripcord.

Pay Off Your Home — For most households that own a home, the mortgage payment is by far the biggest budget line item. If you can eliminate this number, you can hugely reduce your monthly cash flow needs, and keep your income correspondingly small. (As ever, there is a lively and never-to-be-solved debate of whether it makes sense to pay off a low rate mortgage early vs. invest that money, but Obamacare subsidies significantly change this calculus. It’s worth running your own numbers using the Obamacare subsidy calculators above. The extra amount you need to invest to make your mortgage payments in retirement could easily be enough to cost you a big subsidy based on your increased income needs.)

With Travel, Think Cash Now, Miles Later — If you’re a travel hacker, we absolutely understand the appeal of cutting down the cost of travel now. But banking those miles to spend in retirement may be a smarter strategy if your future goal is to keep your spending and corresponding income as low as possible. We absolutely recommend continuing to travel while saving up for financial independence, but we mostly still pay cash to travel now, and bank those miles for the future. (I cross over to 1 million air miles this very week, you guys! Call it my second portfolio.)

Take Care of Your Health — Even with more Americans insured than at any time in recent history (seriously, y’all — record levels, even though most people don’t know that the ACA has spurred this), health care costs are still the leading cost of bankruptcy. Don’t let this happen to you. Eat healthy food, cut out the junk (this will save money too!), dedicate time to exercise, get enough sleep (my biggest health short-coming), and surround yourself with people who make you happy. Taking these steps will ensure that you don’t end up with preventable diseases and will also decrease your odds of contracting the ones we can’t totally control. And in the year or two before you quit working, load up on all the preventive health care you can get, so that you can minimize your health care spending in retirement… though if you get a sweet subsidized plan, you should be able to get all the health care you need without busting your budget.

Take Care of Your Stuff — Stuff isn’t nearly as important as your health, but it can still cost you if you don’t take care of it. Don’t put off home maintenance when the costs will likely multiply instead of just adding up. Keep your car and your complicated gear like bikes tuned up, too. Make sure you store things in ways that increase the lifespan of that object instead of shortening it.

Look for Spending to Trim — The less you can spend in retirement, the less you’ll have to earn. We are never going to tell you to cut the stuff that truly brings you joy, but many of us still have areas of mindless spending where we could tighten things up. Or things we’d unquestionably cut if the stakes were higher — like if we knew we could be paying $100 a month for health insurance instead of $500, or have an out-of-pocket max difference of +/- $6000 a year based on being above or below a key threshold. Trim wherever you can.

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Time to Weigh in!

What’s your take on all of this? Do you intend to keep your income lower than you technically could “afford” to, to keep your health insurance costs predictable? To keep your taxes within desirable limits? Just for the challenge of seeing how little you can live on? Any other benefits of living on a low income that we missed but should add? Or think we’re dummies for intending to live on less than we could afford to, because YOLO? Let us know all your thoughts!

(And, because whenever we mention the ACA, someone asks us to defend the law as though we wrote it ourselves, the reminder: We didn’t write it, we don’t think it’s perfect, but we still plan to get our health insurance through it because 1.) it’s the law now, 2.) we value our health above nearly everything, and 3.) it will be our most affordable option and we’d be fools not to take advantage of it. If you still want to debate us on it, I promise to pepper you with smiley faces. You’ve been warned.) :-) :-) :-) :-) :-)