His withdrawal was a response to an outcry in the Social Democrats' base, with many saying Schulz, who led the party to its worst election result since World War II past year, had broken his promise never to enter a Merkel government.
Mrs Merkel has handed all the top ministries in Germany, including finance and foreign, to the SPD - the price the party demanded to form a government with her following an indecisive general election previous year which saw her party's majority slashed by the anti-immigrant Alternative for Germany upstarts.
Kevin Kuehnert, leader of the SPD youth wing, had strongly criticised the focus on staffing over policy in recent days and said some of the top brass needed "to put their ego on the back burner" so members due to vote on the coalition could focus on evaluating the content of the agreement instead. "I sincerely hope that this (decision) will end the personnel debates within the SPD", Schulz, a former president of the European Parliament, said in a statement.
September's election left her coalition, made up of the same three parties, severely weakened.
Many young and leftist members are against the renewed so-called Grand Coalition between the SPD and the Union. But the final stretch appeared to be more about horse-trading on posts, with the SPD celebrating their advances within the cabinet.
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"The way in which Schulz left could make it hard to quickly focus on the party's achievements in the coalition talks", Carsten Nickel, a Brussels-based analyst at Teneo Intelligence, said in an e-mail response to questions.
His announcement also upset Germany's current foreign minister - veteran SPD member Sigmar Gabriel - who complained of a "lack of respect" and said he was popular among ordinary Germans. He was officially elected by a party congress with 100 percent of the vote.
After the SPD's losses in the September 24 national election, Schulz announced that the SPD would go into coalition and that he wouldn't hold talks with Merkel.
"We shouldn't only talk about how we want to shape the next four years in Germany but also what the CDU will stand for in future, which topics we can win elections with in the next 10 years and people go along with topics", he said.
German Chancellor and leader of the Christian Democratic Union (CDU) Angela Merkel arrives for the coalition negotiations at CDU headquarters on Tuesday.