4 Ways to Sabotage Your Chance of an Early Retirement

By Markets Fool.com

Continue Reading Below

Source: Ed Yourdon via Flickr.

Many people across America are dreaming of an early retirement, whether they can't stand their jobs or they simply crave the freedom to spend their time how and where they want to. Yet some of us are our own worst enemies, thwarting our own early-retirement goals at every turn. We asked our Motley Fool experts to talk about ways they see people sabotage their chances of an early retirement. Here's what they had to say.

Most of us would probably love to retire early, but there's a critical way you might be killing your chances of achieving an early retirement: You might be putting off saving and investing for it, thinking that a little delay won't hurt that much. That couldn't be more wrong, and even if you are saving and investing now for retirement, you might still fall short if you're not being aggressive about it.

To retire early, you will probably need to accumulate a sizable nest egg -- after all, it will have to support you longer than it would if you retired at a more traditional age. The right amount is different for different people, but let's assume you want to accumulate a million dollars and run through a few calculations.

Below is how much you'll need to save each year to reach a million dollars if you have just $100,000 socked away right now. We'll assume that your money will grow at an annual average rate of 8% (the stock market has averaged close to 10% annually over many decades) and that you want to retire at age 55:

Continue Reading Below

Your Age Today

You'll Have to Save...

...for This Many Years

25

$0

30

30

$4,000

25

35

$11,000

20

40

$24,000

15

45

$50,000

10

50

$135,000

5

You probably know that the earlier you start, the better, but facing stark examples like the ones above can help us understand it is to start early and save aggressively. They also demonstrate how those who have several decades before retirement have a much more manageable task.

The average rate of growth that your portfolio experiences will make a big difference, too. If you average 9% or 10%, you'll be able to save less -- but such returns are far from guaranteed. Perhaps play around with an online calculator to see what scenarios will work for you.

One way to sabotage your chance of an early retirement is to buy a second home -- that is, a vacation home.

Second homes are a large financial and time commitment that many people don't fully appreciate until they have taken it on. Vacation homes require as much upkeep as your regular home, if not more, depending on whether you plan to rent it out. You also have to pay for utilities, trash, maintenance, property taxes, and possibly a property manager if you live far away. This is all money you could be putting into tax-advantaged retirement accounts.

There are two important points to realize. First, houses are not good long term investments. Data from housing economist Robert Shiller has shown that houses do not return much above inflation:

Source: Robert Shiller.

The stock market, however, has crushed inflation:

^GSPC Chart

Next, it's important to realize that second homes don't have the tax benefits your regular home gets from the IRS. Most importantly, there is no exclusion for capital gains on a second home as there is with your primary residence. This rule provides a $250,000 exclusion ($500,000 for those married filing jointly) on capital gains from the sale of your home. If you sell your vacation home for a $250,000 gain, you are on the hook for $50,000 in capital gains taxes.

By purchasing a second home, you're using money that could otherwise be in higher-returning and/or tax-advantaged investments. If you want to set yourself up for an early retirement, you're much better off investing in the stock market.

One of the biggest ways to sabotage your retirement is to forget about the impact of taxes during your accumulation and spending phases.

As you aggressively save for retirement and maximize the amount you can contribute to tax-advantaged accounts, you may have to start putting a part of your savings into fully taxable accounts. It's here that every transaction, every dividend, and every gain will have tax consequences. Many of these are out of your control -- for example, active mutual funds can be some of the worst investments to hold in taxable accounts, as portfolio managers can take gains that trigger capital gains taxes that you could have deferred. Therefore save taxable accounts for investments that generate little income and that you plan to hold for a very long time.

Likewise, if you use traditional savings plans -- namely, traditional 401(k)s and IRAs -- to fund your retirement, you'll need to be careful when making assumptions about your withdrawal rate. Each dollar in a traditional account is contributed pretax and is taxed upon withdrawal. This means your tax rate in retirement can have a major impact on how much you can safely withdraw each year, so keep that in mind and plan conservatively.

Dan CaplingerMany people don't save early enough for their retirement, as Selena points out. Yet the surprising thing is that even among people who do save a sizable chunk of their earnings, learning to invest in a way that will produce sufficient returns isn't always a huge priority -- even though it makes a critical difference in your financial success.

For example, using Selena's example above, if you're 40 years old and want to grow your nest egg from $100,000 to $1 million by the time you turn 55, you'll have to save $24,000 a year if you earn an average of 8% per year on your investments. But if you keep too much of that money in ultra-conservative investments and thereby reduce your portfolio return to 4% annually, you'll end up almost a third short -- or you'll have to save more than $40,000 each year in order to make up the difference. By contrast, if you can eke out a 10% average return, your savings needs will fall to about $17,000 per year -- quite a bit less.

Obviously, you can't predict what your returns will be, so being conservative in your planning makes a lot of sense. Still, you can't afford to be too conservative in the way you invest, so getting familiar with higher-return investing methods can make or break your early retirement dreams.

The article 4 Ways to Sabotage Your Chance of an Early Retirement originally appeared on Fool.com.

Dan Dzombak is a long-term investor and writes about happiness. He has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned.Dan Caplinger has no position in any stocks mentioned. Selena Maranjian has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.