The Government is our Silent Partner
All of the money that we spend on our lifestyle is after tax money. Thanks to the income tax, the Government (both Federal and State) is effectively a silent partner in everything we do. In a previous post, I used a $50,000 withdrawal rate as an example. If your desired lifestyle required spending $50,000 a year, you would need to earn enough money so that you would have $50,000 left after paying all your income taxes.
There is a handy and free income tax estimator at https://smartasset.com/taxes/income-taxes. It takes into account both Federal and State tax rates for people filing single or jointly (married). Withdrawals from retirement accounts such as an IRA or 401K are treated as regular income. So, if your withdrawal came from an IRA or 401K, this is the calculator you would use. A single person (worst case) living in California (a high tax state), would need to withdraw about $59,000 in order to have $50,000 after tax. If you look at the calculator results, you will see that the “income after taxes” line is only $45,857. However, your non-salary income is not subject to FICA (Social Security and Medicare taxes) and so the FICA entry for $4,514 would be added back to your income to give a total of $50,371.
One thing to keep in mind is that not all income is treated equally. Money made from the sale of things like stock that you owned for more than a year are treated as long-term capital gains and they have different rules. https://smartasset.com/investing/capital-gains-tax-calculator is the tax estimator for capital gains. If your withdrawal comes entirely from the sale of stock or stock funds, then this is the calculator you would use. This is the most likely case if you have reached financial independence before the age of 55. Do not forget to enter a non-zero value for your annual income. In our example above, we would enter an initial value of $100 (the minimum the calculator allows), a sale value of $59,100, and an annual income of $59,000. In this case, the total tax would be $14,302 (California treats all income as regular income) and you would only be left with $44,698. You would have to enter an initial value of $100, a sale value of $66,100, and an annual income of $66,000 to result in a tax of $16,038 leaving an after tax income of $49,962.
At first glance, one might think that these results make no sense. Aren’t long-term capital gains supposed to be taxed less than ordinary income? Well, it turns out that this only true for relatively well off people. Because of the flat nature of the long-term capital gains tax, one would pay more taxes on long term capital gains than on regular income for amounts larger than about $40,000 but less than about $165,000.