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Personal Finance FAQ

Should You Pay Yourself a Paycheck If You REFIRED?

Taxes grow without rain.
–Jewish proverb

My wife and I REFIRED at the end of 2019, with the intent of living solely off of the profits of our real estate investments.

Since I am on some boards, I receive income from those boards, and, because of that earned income, we’re still able to contribute to our IRAs.

However, at some point, either the companies will be sold, or they’ll grow to the point where it makes sense to bring in someone with that specific experience, and I’ll step aside.

As such, we won’t have earned income.

We’ll still live off of the profits of our real estate and supplement that income, where necessary with tax loss harvesting.

However, would it make sense for our real estate “business” to pay one of us?

When I first started thinking about this question, the immediate gut reaction was that the answer was no. After all, why would I pay 15.3% in self-employment taxes up to $137,700 of income?

The first thought was that by paying myself at least $12,000, I’d be able to contribute to both of our IRAs.

But, since I live in Texas, I’d have to pay myself the minimum wage (I believe…I’m not a labor attorney) of $15,080 per year.

So, I’d potentially be paying $2,307.24 per year in self employment taxes to be able to contribute $12,000 to an IRA. Ostensibly, that’s 21% to either defer (paying in the case of a traditional) or never pay (in the case of a Roth) taxes again.

However, the employer portion of self employment tax is deductible, meaning that 7.65% of the income, or $1,153.62 is deductible.

But, that makes a tiny impact. For someone in the 12% tax bracket, that would equate to a $138.43 reduction in taxes, meaning a net tax payment of $2,168.81 to contribute to an IRA.

Then, I remembered that I’d written about another important tax benefit for lower income earners.

As I wrote about in “The Saver’s Credit Cliff,” the IRS gives tax credits for low AGI earners who contribute to IRAs.

Thus, depending on what my AGI was, I could also earn a credit for the same plan.

Would the credit offset the increase in taxes?

Let’s assume that we are filing married filing jointly for 2020.

We take the standard deduction of $24,800 for married filing jointly for 2020.

If we contributed $12,000 to a Roth IRA, so not receiving any tax benefits, and did not have a healthcare savings account contribution to further cause adjustments, then how much could our AGI be without paying myself a $15,080 annual paycheck to make this plan worthwhile?

It turns out that if we had an AGI of $64,953 or less, we’d be better off paying me a paycheck.

Why?

At $64,953 in adjusted gross income, we would, in 2020, pay $4,423.24 in taxes.

If we pay me a paycheck, then we would, as I mentioned before, pay $2,307.24 in self employment taxes.

However, the paycheck and the employer portion of the self employment tax would be deductible, leaving us with a new adjusted gross income of $38,999.38.

We would, according to the tax tables, owe $4,284.81 in taxes.

So far, it looks like we’re paying $2,307.24 to save $138.43 in taxes. Great deal (he said sarcastically)!!!

But, wait, there’s more!

Because our new AGI is under $39,000, we’re eligible for 50% of what we contributed to our IRAs, up to $4,000.

That maxes out our tax credit at $4,000, reducing our total tax bill to $284.81.

This means a difference in the favor of paying myself a W-2 paycheck of $1,831.19.

If you don’t want to roll your own payroll, then you could pay $210 at Intuit to handle your payroll and filings for you, meaning that your total savings would be $1,621.19.

There’s an additional benefit, at least for me, that is beyond the scope of this article.

Since I have less than 35 years of contributions to Social Security (early retirement, yo!), then there’s an added benefit of an expected return on my future Social Security payment. As Michael Kitces thoroughly outlines, I can probably expect about a 2% inflation-adjusted return on that Social Security taxation. Double win!

Have you considered paying yourself a W-2 paycheck from your real estate income in retirement? Let’s talk about it in the comments below!

By Jason Hull, CFP®

Jason Hull, CFP®, was the co-founder of Broadtree Partners, a firm that acquires $1-5MM EBITDA companies. He also was the co-founder of open source search consultancy OpenSource Connections, a premier Solr and ElasticSearch firm. He and his wife FIREd (financial independence retire early) at 46 and 45, respectively. He has a BS from the United States Military Academy at West Point and a MBA from the University of Virginia Darden Graduate School of Business.

You can read more about him in the About Page.

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