How to Retire Early

The first step when planning for an early retirement is to figure out exactly how much money you have right now. This is called your net worth. Net worth is calculated by adding up all of your assets (cash, stocks, retirement accounts and the value of your home) and subtracting all of your outstanding debt (mortgage, student loans and credit card debt).

When you know how much you have, you need to figure out how much money you'll need when you retire. This amount depends on several factors: what you want to do when you retire, how early you want to retire and what standard of living you want to enjoy when retired.

If you want to keep up your current standard of living as a retiree, the rule of thumb is that you'll be spending monthly at least 80 percent of what you're spending now [source: MSN]. That other 20 percent you won't be spending accounts for work-related expenses: gas or public transportation fares for your commute, dry cleaning bills, lunches and the like. But if you plan to travel, play more golf or fix up a classic car as a retiree, you'll quickly make up that 20 percent you thought you were saving by not working.

Perhaps the most important factor when calculating how much you'll need is how early you want to retire. There's a big difference in planning for a 20-year retirement and a 40-year retirement. Plus, the earlier you retire, the longer you'll have to wait to get Social Security benefits. This isn't a problem for people who retire after the minimum age for collecting Social Security (currently 62). But if you retire too early, you might not have enough to get by on until Social Security kicks in.

Another serious consideration when planning for an early retirement is health insurance. When you're employed, you pay part of your monthly insurance premium and your employer pays the rest. When you retire, you're guaranteed coverage under the same insurance policy for the next 18 to 36 months through the Consolidated Omnibus Budget Reconstruction Act, also known as COBRA. COBRA is meant as a temporary protection for employees who lose or change jobs. But even with COBRA, you'll be paying the full premium, including what your boss used to pay.

You're not eligible for Medicare benefits until you're 65 [source: MSN]. So, until you reach that age, you'll need a supplementary insurance policy. When you apply for a new policy after COBRA runs out, you might be surprised at how expensive it is to insure a 60-year-old with pre-existing medical conditions. The cheapest policy for a 62-year-old nonsmoker is $300 a month, and it increases if you smoke, have a history of heart problems, high blood pressure, diabetes and other conditions [source: MSN].

One way to get started on your early retirement budget is to use one of the many free online retirement calculators to figure out how much you'll need in net worth to retire at a certain age. But the only way to know if your planned retirement spending will work is to try a dry run [source: Kiplinger]. Try to live for three months on the projected monthly amount that you hope to live on when retired. If it's not working now, it certainly won't work when you factor in increased healthcare and insurance costs.

How can you start saving for an early retirement now? What are the best long-term investments for building up a retirement nest egg? Keep reading.

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.

There are some traps to avoid when planning for early retirement. The first has to do with Social Security and how your retirement benefits are calculated. The Social Security Administration (SSA) bases your monthly benefits on the average of your salary during your 35 highest-earning years of work. If you retire too early -- before you've worked for 35 years -- then your nonworking years will be counted as zeros.

It's also important to understand when you should start collecting Social Security. The SSA allows you to start collecting Social Security benefits at 62, but that's not considered "full retirement age." If you were born before 1937, your full retirement age is 65, but if you were born after 1960, it's 67. Full retirement age means that you'll receive your full Social Security benefits only if you wait to collect until you're 65 or 67. If you start collecting at 62, you'll receive only a partial benefit. Calculated over the length of your retirement, you'll receive 25 percent less Social Security benefits if you start collecting at 62 as opposed to waiting for your full retirement age [source: SSA].

Inflation is another hidden trap when planning for your financial future. The average annual inflation rate is around 3 percent. At that rate, your money will be worth considerably less 30 or 40 years down the road. One million dollars in 2008 will be worth less than half that amount in 30 years. Wages tend to keep pace with inflation but not investments. If an investment has a 5 percent rate of return, that's really a 2 percent rate over the long term when adjusted for inflation.

There are also some important tax considerations to keep in mind when planning your future finances. As we've mentioned, there are tough tax penalties for withdrawing money early from a 401(k) or IRA. For both 401(k)s and IRAs, there's a 10 percent penalty for withdrawing funds before the age of 59.5. There are some exceptions to that rule: disability, the purchase of a first home, hardship withdrawals for medical expenses, and a 72T. A 72T allows you to withdraw money from a 401(k) or IRA in even disbursements based on the amount of money you have and your projected life expectancy.

If you need or want to go back to work after you retire, be wary of earning too much. If you file individually and make between $25,000 and $34,000, you'll have to pay income tax on 50 percent of your Social Security benefits. Earn more than $34,000 a year, and you'll be paying on 85 percent [source: SSA]. Also, if you retire before your full retirement age and pick up a part-time job, Social Security can reduce your benefits by $1 for every $2 you earn until you reach age 65 or 67.

So what exactly are you going to do when you retire? And where are you going to retire? Keep reading to see what the experts have to say about retiring early and staying busy.

If you're thinking about retiring early, you should ask yourself why. Is it simply because you don't like working? Maybe you'd be better off looking for a job that's more fulfilling so that you could enjoy more of your time and money now, rather than saving it for an unpredictable future.

Strong motivation is the key to a successful early retirement. Maybe it's always been your dream to move to the South of France and write a novel, to dedicate your time to charity work or your church or maybe you just want to spend every day fishing. A powerful motivation won't only make your early retired life more enjoyable, but will also make it easier for you to stick with a strict financial plan until you get there. Some experts even suggest getting a psychological evaluation to help discover what type of early retirement fits your personality type [source: MSN].

More and more retirees are planning to work through the early part of their retirement, whether full- or part-time. According to a 2006 survey by the Pew Research Center, 77 percent of today's workers plan to do some kind of paid work past their full retirement age. Interestingly, those numbers don't reflect the current reality. Right now, around only 12 percent of retirees are working, although 27 percent have worked at some point during retirement [source: Pew Research].

Working at least part-time during retirement can be a smart move for people whose friends and spouses are still working or for those who don't have established hobbies or interests. Plenty of retired business executives pick up post-retirement work in sporting goods stores, and retired teachers might choose to work at local daycare centers.

The stark reality is that many of today's retirees didn't plan on being retired so young. A 2006 survey found that 40 percent of retirees were forced to stop working earlier than they had planned for reasons ranging from illness to unemployment [source: USA Today]. And now that they're retired, they realize that they don't have enough savings and investments to support themselves for the long-term. So, it's back to the want ads to find something to make ends meet -- at least until Social Security kicks in.

If you figure that you have about 20 to 30 years to enjoy retirement, you can find ways to stretch your dollar and your time. While you're freshly retired, you can explore hobbies and part-time work, and when you start collecting Social Security, you'll have more financial wiggle room to indulge in lifelong dreams like world travel or volunteer work. And if you plan wisely, you'll have enough savings stashed away to cover unforeseen medical expenses and possible long-term care.

For more information on retiring early, financial planning and related topics, consult the links on the next page.