Employees—especially those new to investing—commonly ask, “What are the limits to my 401(k) or IRA investments?” This article will discuss those limits, how and when they are set, and how they might change in the future.
In 2021, the 401(k) contribution limit is $19,500. Anyone age 50 or over can contribute an additional $6,500 of “catch-up” funds. The IRA contribution limit is $6,000, with an additional $1,000 permitted for anyone over age 50.
For 2022, limits on 401(k) contributions will jump to $20,500. Catch up contributions and IRA’s contributions remain unchanged.
The Internal Revenue Service (IRS) determines these limits. Every autumn (typically October or November), the IRS reviews the contribution regulations for various retirement plans, such as 401(k)s, Individual Retirement Accounts (IRAs), Health Savings Accounts (HSAs), and more. For example, the IRS released its 2021 update on October 26, 2020.
The IRS limits contributions to retirement plans in order to prevent highly paid workers from benefitting more than average workers. Due to their higher income, highly paid workers could in theory use 401(k) plans or IRAs as a sort of “tax haven.” The IRS prefers that not happen. Thus, they cap annual contribution limits. The IRS’ goal—preventing the rich from benefiting more than the average person—is another reason why access to Roth IRAs is phased out for people whose modified adjusted gross income, or MAGI, is above $140,000 for individuals or above $208,000 for married couples filing jointly.
In general, the IRS determines how to increase retirement plan limits using cost-of-living data. In other words, the IRS uses an inflation-like metric to increase contribution limits. As wages rise and life gets more expensive, the IRS believes that tax advantages should apply to a larger share of your retirement savings.
However, inflation only explains a portion of contribution limit increases over the years. From 2000 to 2020, cumulative inflation was 46% (using Consumer Price Index data), while 401(k) contributions (standard) increased from $10,500 to $19,500—an 86% increase.
What could explain the remainder of the contribution increase? Perhaps the Federal Government is trying to further increase retirement savings rates. Increasing retirement plan contribution limits is a terrific incentive dial for them to turn.
However, the IRS does not raise contribution limits each year for each plan. For example, 401(k) contribution limits (for employees under age 50) have increased 13 times in the 21 years since 2000. All of those increases have been either $500 or $1,000. Clearly, the IRS prefers to deal in round numbers—likely to make the limits easier to remember and utilize for average citizens.
Retirement account contribution limits--and how they change over time--is an important idea for both investors and investment advisors to understand.