If early retirement is a dream of yours, congrats! You’re probably already working hard to make that goal a reality. Just as important as knowing what to do, is being aware of potential pitfalls that could get in your way. Here I’m going to share the top 3 mistakes to look out for – and how to avoid them! – on your way to early retirement.
- Not having a Roth IRA and maxing it out every year. Why this is a mistake: Did you know you can take your principal out of a Roth without penalty at any time? If early retirement is on your horizon, this can be a powerful tool because you can tap into it before age 59 ½ (the age you have to wait for most retirement accounts like IRA’s and 401ks to become penalty-free). Otherwise, you could be throwing away money in penalties or getting stuck in a 72(t) payment from a traditional retirement account.
Another benefit of having a Roth: having a Roth bucket also gives you more control over your taxes. We call it “riding the tax brackets.” Here’s how it works: after age 59 ½, you can take money out of a pre-tax account like a 401(k) up until you reach the edge of a tax bracket, then take the rest out of a Roth account. Since the Roth distributions are tax-free, they can enable you to maintain your lifestyle while potentially staying in a lower tax bracket. Win-win! But you have to be building your Roth bucket early and consistently to use this strategy in retirement. Without it, as IRA expert Ed Slott says, you could be building a “tax time bomb.”
What to do instead: High earners are often told that they make too much money to contribute to a Roth, so they give up. But this is a misunderstanding. As of today, you can still make “backdoor Roth” contributions no matter how much you earn (find a financial advisor who knows how to do this properly). Also, if your workplace plan offers a Roth option (ie, Roth 401(k) / Roth 403(b), for example), these plans have different rules and act independently from a Roth IRA. You could actually be doing both: contributing to a Roth 401(k) and to a personal Roth IRA, to get maximum benefits. Anyone can contribute to a Roth if they know how to do it. (We can help with this!)
- Having a car payment that’s too high. Why this is a mistake: if you want to retire early, you need to be hyper-focused on that goal and be willing to minimize the noise of short-term distractions, like fancy vehicles. Every dollar you put towards a car is a dollar you are not putting towards your future freedom. You are basically chaining yourself to an object which can do nothing for you in 10 years or so. Is that in alignment with your goal to retire early? Probably not.
What to do instead: when you are looking for a vehicle, do your homework and shop around. Your car payment should not be more than 10% of your take home pay. Know what that number is for you and do not negotiate any higher, no matter what. Draw a line in the sand. Get creative, go elsewhere, or change your requirements if need be. Ask yourself: do you want to be the driver of a fancy car, or the driver of your financial future?
- Saving a lot but not investing the money. Why this is a mistake: even with interest rates finally making savings accounts worthwhile, you cannot get ahead of inflation and retire early by putting everything into savings accounts or CD’s. You need to put your money to work, and this means investing needs to be part of your overall plan.
What to do instead: first, dip your toe into the water by investing a portion of the money you have saved. A good rule is to keep 3-6 months of expenses in savings for emergencies, then consider investing whatever amount is above that. You don’t have to choose aggressive investments to start out. Balanced funds can be a good starter investment as you get more comfortable with investing. Also, knowledge is power. There are plenty of investing classes out there to help you learn the fundamentals. I recommend investigating who is presenting before you sign up. Shy away from “educational” presentations that are sponsored by a fund company or sales agency and opt for non-biased classes from an independent financial planner or a non-profit organization who is more likely to provide a balanced view.
Early retirement can be accomplished through diligent habits and thoughtful planning, so go for it! If you need a guide along the way, let us know – that’s what we are here for. I’d love to have a conversation about how to make that happen for you.
