Retire Early by Following These 3 Rules

Before you go, we thought you'd like these...
Before you go close icon

Do you want to retire early? Most Americans would answer a firm "yes" -- and they might add, "The earlier, the better." In fact, early retirement has become a much higher priority for millennials than it has been in the past: It's the most important financial goal for 26% of those age 18 to 34, a 6% increase from 2011. So if you want to retire at 60, 55, or sooner, here are the three things you need to do now to give yourself the best chances.

Use your best investment "weapon"
For millennials in particular, taking advantage of the time you have is the most surefire way to retire early. If you start saving for retirement in your early 20s, you can let your money compound for 35 years and still retire well before your 60th birthday.

Consider a hypothetical investment account into which we deposit $5,000 each year. Let's assume that we make 9% annually on our investments from a combination of dividends and price appreciation -- approximately the S&P's historical average -- and that once we retire, we can earn 5% annual income on our investments. The annual income from our portfolio goes up dramatically the longer we let it compound.


Annual Income on $5,000 annual investment compounded at 9% | Create Infographics

Despite the advantages, far too few Americans take advantage of the power of compound interest.     

According to one survey, the average American between ages 25 and 32 has just $12,000 saved for retirement. According to The New York Times, a good rule of thumb is to have half of your annual salary saved by the time you reach 30 years old. So even though retiring early is a priority, millennials need to start putting their money where their mouth is to avoid the "retirement crisis" we keep hearing about.

50% more from Uncle Sam
The second-most powerful investment tool at your disposal is tax advantages. Now that you're investing at an early age and hoping to retire early, the last thing you want is for the government to take a bite out of your money.

Before investing through a traditional brokerage account, you need to max out your IRAs first. Roth and traditional IRAs are both tax-advantaged, and I recently wrote a detailed article about the differences between the two. But in a nutshell, the main difference is how they are taxed.

Traditional IRAs allow you to deduct your contributions from your current income taxes, saving you a good chunk of money now. Roth IRA contributions are not deductible on your current taxes, but all qualifying withdrawals are tax-free once you turn 59 and a half. Both accounts allow your money to compound tax-free until you withdraw it, which is a big deal, especially for dividend-paying investments.

Let's say you buy $1,000 of a high-dividend stock like a mortgage REIT paying out a 10% annual dividend. For simplicity's sake, we'll assume the share price doesn't increase over time. Over 30 years of investing in a taxable account (dividends are taxed at 15% for most tax brackets), the original $1,000 investment would grow to about $11,560. Pretty good, right?

However, if those dividends were allowed to compound tax-free, as in an IRA, the ending value would be nearly $17,450, or more than 50% higher than in the taxable account.

It's easy to see why taking full advantage of the tax breaks available to you is essential to an early retirement strategy.

Social Security, pensions, and your home equity should only be extras
Now, this isn't really something you have to do, but rather a mind-set you need to train yourself to invest in.

A lot of people have a 401(k) plan at work. If you do, you should be contributing the maximum amount your employer is willing to match. Or maybe you have a pension plan, which is more common if you're a public-sector employee. And of course there is Social Security, which you'll be able to collect at age 62 if you want -- right?

If you truly want to retire early, don't count on any of these things, for a couple of reasons. First, no one knows what the state of Social Security will be when you reach retirement age. For all you know, the full retirement age could be 75 by then! Pension benefits are continuously being eroded and in many cases are cut severely if you collect benefits before the full retirement age your plan specifies.

Second, the most successful investors take control of their retirement. Invest as if your retirement savings are all you can count on. If Social Security is still intact in its current form, and your 401(k) balance is as big as you'd hoped, that's wonderful. It'll make your retirement that much sweeter. But the only truly safe play is to take control of your own destiny. A recent study found that 26% of retirees in America rely solely on Social Security benefits, which is mainly due to lack of retirement planning. Don't let this be you!

Getting to your number
According to Fidelity, a good goal to shoot for is eight times your ending salary in investment accounts by the time you retire. So if you and your spouse combine to make $100,000 per year, you should shoot for $800,000 in retirement savings.

Your particular "retirement number" could be more or less than this amount, depending on how frugally or lavishly you want your retirement to be, but if you take advantage of the tools at your disposal and invest like you're the only one you can depend on, you could retire early more easily than you may think.

Top dividend stocks for your early retirement plan
The smartest investors know that dividend stocks simply crush their non-dividend-paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.

The article Retire Early by Following These 3 Rules originally appeared on Fool.com.

Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2014 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

Read Full Story

Want more news like this?

Sign up for Finance Report by AOL and get everything from business news to personal finance tips delivered directly to your inbox daily!

Subscribe to our other newsletters

Emails may offer personalized content or ads. Learn more. You may unsubscribe any time.

From Our Partners

13 People Recount Their First Kiss Horror Stories 13 People Recount Their First Kiss Horror Stories
Man Suspects His Wife Is Cheating On Him - Then His Daughter Reveals What's Really Going Man Suspects His Wife Is Cheating On Him - Then His Daughter Reveals What's Really Going
Large Numbers Of Horses Are Being Stuffed Into These Crates For A Despicable Reason Large Numbers Of Horses Are Being Stuffed Into These Crates For A Despicable Reason