First time flyers on Southwest Airlines are easy to spot at the boarding gate.  They’re notably confused, trying to figure out the purpose of the stainless steel posts with numbers on them and what they should do with the unusual B22 zone assignment on their boarding pass.  Someone eventually helps them find their spot in line and a few minutes later they’re again dumfounded when the gate agent keeps the boarding pass.

Those who have experienced this process before know that a single-file line establishes using pre-assigned zones on the boarding pass and these numbered posts as a guide.  This line then moves orderly aboard the plane with passengers selecting from among all remaining open seats.  There are no pre-assignments.  Aisle and window seats near the front of the plane fill first, followed by aisle and window seats in the back, then followed by middle seats in front and middle seats in back.

I suspect that few of us, if any, who travel on Southwest have ever witnessed someone refuse to fly because he/she was saddled with the less desirable option of only middle seats or, God forbid, a middle seat in the back of the plane.  Nearly all passengers prefer sitting at the window or aisle but the overriding objective is reaching the destination in a timely manner.  As a result, passengers bear the discomfort of a middle seat in order to achieve the primary objective.

This is all logical and you probably never considered waiting for the next flight just to avoid a middle seat.  Yet there are many individuals who, when faced with the option of only middle seats, choose to wait for the next flight and delay arrival at the destination.  Making matters worse, this destination is not some family reunion or weekend getaway but retirement.

You see, the parallel alluded to here is the tendency of successful working families to stop saving for retirement once tax-favored options are no longer available.  Rather than accept the middle seat (saving beyond what a 401(k), 403(b), or other retirement plan permits), many families or individuals accept the expense of delayed arrival (retirement).  It may be an unintended decision but it is still a decision with important consequences.

Aisle or Window to Retirement, Please

The most common corporate retirement accounts, 401(k) and 403(b) plans, limit annual employee contributions to $17,500 in 2014 (plus an additional $5,500 for anyone over age 50).  Of those professionals who are successful enough to make a healthy salary, we find that many link their savings to these statutory limits.  They save enough to maximize retirement plan contributions and then spend the remainder despite the fact that they could be saving more.  If you find yourself in this situation, consider the (probably) unintended implications:

1) You’re effectively allowing the government to dictate how much you save and spend.  Realize that if you tie your savings to retirement plan limits set by the IRS and spend the difference, the government is effectively controlling the amount you spend and save.  The statutory limits for retirement plan contributions are not limits on how much you save unless you let them be limits.  Perhaps you never deviate from the speed limit and prefer to have all your decisions made for you from Washington DC.  Or perhaps you prefer to make your own decisions about spending and saving.

2) You’re assuming the government knows how much you need to save to achieve your personal retirement goals.  Let’s be honest – the IRS did not set retirement plan contribution limits because they happened to be the right amount for you to save and retire on time.  The IRS restricted contribution limits to prevent high income earners from sheltering huge amounts of income from tax each year.  The probability that $17,500 is the amount you need to be saving to achieve your objectives, no more and no less, is basically zero.

To demonstrate the perils of a family who restricts savings to the statutory limits, let’s consider an example:

  • 40-year old couple with a life expectancy of 90.
  • $300,000 saved in a 401k plans, no debt, and both spouses working to make a combined $250,000/year.
  • Both save the max ($17,500/each) in 401k plans with 3% employer matches.
  • Effective tax rate of 25% and they spend the net income that is not saved.
  • Eligible for maximum Social Security benefits, starting at age 67.
  • Achieve a 6.2% return on investments with a volatility of 13.1%.
  • Earn annual raises of 3% and increase 401k contribution amounts by the same 3%.

On the surface, this hypothetical family might seem on their way to retirement success.  They’ve paid off all debt by age 40 and saved $300,000.  In addition, they’re maximizing 401k contributions of $35,000/year and increasing those contributions by 3% each year.  Yet running out this scenario, both husband and wife must work until age 75 to successfully retire.

This situation is not uncommon.  Many successful families make a good habit of annually maximizing 401(k), 403(b) or SEP IRA contributions and stopping there.  The result tends to be that they then have to either make a material lifestyle change or delay retirement.  For high earners, using the arbitrary retirement plan limits as a savings target and hoping to retire before 65 is almost always a failed equation.

Another problem with this approach is that it limits tax planning in retirement.  We occasionally meet with families who diligently saved the maximum to retirement plans each year but never a dollar beyond.  Now they’re retiring with 100% of savings in a traditional retirement plan account or an IRA and looking for tax planning guidance.  Unfortunately, this family has limited ability to manage income in retirement except by reducing their spending.  Every dollar they spend will be ordinary income and they are unknowingly fully exposed to the risk of rising tax rates.

Evaluate Your Middle Seat Alternatives

There are two basic steps that high earning families should take to get on the right savings plan:

1) Start with financial goals and work backwards from there.  Rather than just saving what the government allows in tax favored accounts, start with your objectives.  When do you hope to retire and what kind of lifestyle do you envision?  We work with clients to develop a financial plan that can then help to answer important questions.  In many cases, the client might ask, “Am I saving the right amount?” or “How much should we be saving if we want to retire at age 60?”  These are the critical questions to be asking – not how much will the IRS let me save in a tax favored account.

2)  Once you know how much you should be saving to meet your objectives, make educated decisions about how to optimize.  You may have other tax-favored options that extend beyond a traditional retirement plan such as using an HSA as a retirement vehicle or back door Roth IRA contributions.  If you own a business (or have a small side business) there may be options to increase your tax favored savings.

Even without these additional options, traditional brokerage accounts can be highly tax efficient if used properly.  Owning low turnover equity ETFs or index funds in a brokerage account is often more tax friendly than holding these positions in a tax deferred account like a 401(k).  Moreover, the intelligent placement of tax-efficient and tax-inefficient assets in accounts through a process known as asset location helps to exploit tax code irregularities and make brokerage assets a useful complement to 401(k)s and IRAs.

Importance of the Destination

Flying with Southwest Airlines enough, you will occasionally board the plane to realize that only middle seats remain.  You probably never consider waiting for the next flight to get an aisle or window.  That is logical.  We suggest you make the same choice with your retirement planning.  Determine your destination, figure out what it takes to get there, and then make best use of the options available – even if that sometimes means the middle seat.

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