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How to Retire Early

Investing for Early Retirement
Bet this retiree is happy that he started saving while he was young.
Bet this retiree is happy that he started saving while he was young.
©iStockphoto/Steve Luker

Compound interest is a beautiful thing. The best thing you can do right now to ensure an early retirement is to invest as much of your earnings as possible in safe, long-term investments and tax-deferrable retirement savings accounts.

A good place to start is with a tight budget. As we learned in How to Make a Million Dollars, one of the quickest ways to become rich is to live a frugal lifestyle. Instead of living beyond your means -- buying things on credit that you can't immediately pay back -- live below your means. Buy a used car instead of a new one (or better yet, take the bus). Choose the two-bedroom house instead of the five-bedroom one.

So, how much money should we be saving from each paycheck? MSN Money describes a 20/20/20 system. Starting at age 20, if you invest 20 percent of each paycheck, you could retire in 20 years and live on the interest from your investments [source: MSN]. As we've already asked, can you live right now on 80 percent of your income, like you'll be living on in retirement? Try setting up an automatic withdrawal from your checking account. Whenever a paycheck is deposited at the bank, 20 percent will automatically be deducted before you even have a chance to see it, let alone spend it.

Now you need to take that money and invest it in something with guaranteed long-term growth. MSN Money recommends a stock market index fund that tracks S&P 500 companies. So as long as the stock market goes up over the next 20 years -- which it historically has, at a rate of 12 percent annually -- your money will grow. Also, if you can increase your earnings slightly every year through pay raises and promotions, you'll see even more growth.

Stock investments are smart if you plan on retiring before you're in your 60s. When you start cashing in stocks at age 40, you'll have to pay only long-term capital gains taxes, which are currently at 15 percent. But other common retirement investments, like 401(k)s and Roth IRAs, have stiff penalties for withdrawing money early. The minimum age to start withdrawing from a 401(k), a Roth IRA and a traditional IRA is 59.5.

And remember, don't touch the interest on your stock investments. For the magic of compound interest to work, you need to reinvest every penny of interest.

Next, let's look at some common mistakes people make when planning for an early retirement.