I'm going to talk about two things in this article: one, why you as a tech professional should be prepared to retire early (even if you love your job!), and two, how you can go about doing that in the most tax-efficient way.
Be ready to "call in rich"
In my engineering days, I loved my job. One of the hardest decisions I ever made was to leave the engineering field, and the only reason I did so was because I loved being a financial advisor even more. (That's a story for another day.) It was hard, and sometimes stressful, but fulfilling, and I know that many of my former colleagues feel the same way. Regardless, I exhort all of you employed tech professionals out there: be prepared to retire before 60.
Note: the focus here is on being prepared to retire early, not on actually retiring early. There are a couple reasons for this:
First: do you want to be at the mercy of your employer? I'm sure many of you have heard anecdotes about older tech professionals being "encouraged to retire" before 60, to make way for younger (read: cheaper) ones to take their place. Whether or not that's actually true in your particular case is up for debate. This article on engineering professionals from labor market analytics firm Emsi slices up the data in some interesting ways, showing that while engineers as a whole tend to skew older than other professions, some engineers -- e.g. computer hardware and biomed engineers -- skew much younger, likely because those professions are relatively new. Moreover, software engineers* aren't on the list at all, so it's unclear where they fall on the spectrum.
Regardless, one thing is clear: we no longer live in a world where employment is virtually guaranteed until 60. My home state of Texas in particular is very much an "at-will" state, where you can quit or be fired at any time. Given that, I highly recommend you construct a safety net for yourself. While I'm sure you're creating a ton of value for your company, employers sometimes make decisions that go against their own long-term self-interest -- especially in an economic downturn. And if you get laid off in your mid-50's or later, just having the option of retirement will make your life an order of magnitude easier. That gives you time to take a break, spend some time with family, and then start casually networking to see what other jobs are out there. And if there's a downturn going on and there aren't any reqs out there, you'll have the wherewithal to wait it out until hiring starts back up again. Or who knows? Maybe you'll find "retirement" even more engaging than full-time employment. The 21st century may have its flaws, but boredom is rarely one of them.
Second: people change. Sure, you love your work now -- but will you in your 50's? Maybe you start burning out. Maybe you want to finish out your career in a job that pays less, but is more rewarding. Maybe you like engineering, but decide you just want to do it part-time -- perhaps as a contractor who just works for a few months when they feel like it, then goes golfing or traveling for a few months until they get the itch to work again. Maybe you want to be able to work at a startup without having to bank your future on whether it succeeds. Or maybe you want to switch to a different career entirely, without the pressure of ramping up in a certain amount of time.
Will any of those options appeal to you? Maybe. The good news is that some smart saving now can give you the flexibility to take them later -- without unduly sacrificing your current standard of living. And if you continue to work to 65 and beyond, well -- all the more resources for you to live and give how you want!
How to save for early retirement
So you've decided you want to save for early retirement. Good on you! However, you've probably noticed that most tax-advantaged savings vehicles (401(k)'s, 403(b)'s, IRA's, qualified annuities, etc.) assume that you'll retire at 59.5 at the earliest. You might think this means that you have to take some of the savings you would otherwise put into a 401(k) and contribute to a plain vanilla brokerage investment account instead.
You would be wrong.
The good news is that the IRS and Department of Labor actually have some tools in place to help people retire when they want, even if it's before 60.
First: consider a Roth IRA. Most people who have done some research are familiar with the basic tax benefit of a Roth IRA versus a Traditional IRA: the former is funded with post-tax dollars but grows tax-free, providing no tax deduction now but tax-free withdrawals in retirement, while the latter provides a tax deduction now but is taxed upon withdrawal. However, many aren't aware of another interesting wrinkle in a Roth IRA: provided you've had a Roth IRA (any Roth IRA, not just the one in question) for five years, you can withdraw your contributions (not earnings) from any Roth IRA account at any time, for any reason. Now, I don't often recommend doing this for any purpose other than early retirement, but Roth IRA's absolutely shine when you're looking at any form of early retirement. For example, the extreme flexibility here means that you could have a temporary "mini-retirement", where you take off for a year or more to look for a new job or ramp up a new career, and then put said retirement on hold once you've built your income back up.
Of course, you can only contribute directly to a Roth IRA if your gross income is less than $133,000 (single) or $196,000 (married)**. The good news is that employers are increasingly offering Roth 401(k)'s. The bad news is that Roth 401(k)'s do not provide the same flexibility as Roth IRA's -- in order to tap the principal penalty-and tax-free before 59.5, you would have to roll over to a Roth IRA, and have contributed or rolled over to a Roth IRA 5 years prior to withdrawals.
Second: remember the Rule of 55. Another weapon in the early retirement arsenal is the Rule of 55: if you retire (or are forcibly "retired") from your employer between ages 55 and 59.5, you can withdraw the money from your 401(k) or 403(b) with said employer penalty-free. Note: this is only for that account: neither IRA's nor accounts with other employers qualify for this rule.
Third: Section 72(t) withdrawals. Section 72(t) withdrawals are also known as "Substantially Equal Payment Plans", whereby you can set up a systematic series of withdrawals before your turn 59.5. A few things to bear in mind:
SEPP's apply to all qualified retirement plans (401(k)'s, 403(b)'s, etc.) and IRA, SEP, and SIMPLE IRA plans.
The amount of the withdrawals is determined by one of three formulas: required minimum distribution, amortization, and annuitization. All of them use actuarial tables, but the first generally gives the lowest withdrawal rate, and the second and third give you some flexibility in that you can determine an interest rate. You can only change the calculation method once during the life of the SEPP, so choose wisely.
Each SEPP is set up for a single account, not your entire qualified retirement portfolio, so if even the required minimum distribution method still gives you more income than you want, you can roll some funds into another account and set up the SEPP on the smaller balance.
The SEPP must last for 5 years or until you turn 59.5, whichever is longer.
SEPP's only shield you from the 10% early withdrawal penalty. Otherwise, normal tax rules apply.
While SEPP's apply to the widest range of accounts, you have much less flexibility than Rule of 55 or Roth IRA withdrawals once the payments start. This option is best when you're considering true full- or part-time retirement, rather than a temporary mini-retirement or on-again/off-again partial retirement.
Even if you're nowhere close to retirement, here are some key takeaways:
Don't use early retirement as an excuse not to max out your retirement accounts before contributing to a brokerage account. Per above, there are plenty of ways to tap your retirement accounts for early retirement.
If you're under the income limit, consider contributing to a Roth IRA now. Even if it's just a little, simply opening the account and contributing can be incredibly beneficial where the 5-year rule is concerned.
Consider carefully what to do with your 401(k) or 403(b) when you change employers. In particular, consider whether you might want to take advantage of Rule of 55 or 72(t) withdrawals; in the case of the Rule of 55, you may want to roll over your old 401(k) into your new employer's plan, though you should be aware that 401(k)'s have limited investment options and often higher expenses than IRA's. Also, if you have Roth 401(k) contributions, don't yet have a Roth IRA, and are over the income limit to contribute to one, you might consider rolling those funds over into a Roth IRA to get the 5-year rule ticking.
Of course, Seaborn specializes in integrating a Roth IRA into the rest of your financial plan. Take a look at our services here.
* Yes, software engineers are engineers. I'm sure those scripts you wrote are just fine for your personal use, but they might not stand up to scrutiny. You should get a software engineer to look at them -- just for entertainment value.
** "Backdoor" Roth IRA contributions for those who exceed the income limits are a subject for another article.
Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.