Saving for retirement can be a challenge, but tax-advantaged accounts such as 401(k)s and IRAs help make investing for the future easier. Both offer tax breaks for saving in the year you make the contributions. And both allow you to defer taxes on gains until you begin making withdrawals as a retiree, at which point you're taxed on distributions at your ordinary income tax rate.
But while IRAs and 401(k)s have many similarities, 401(k) accounts have a very important advantage over IRAs. And that advantage is getting bigger in 2021. Here's what it is.
401(k) accounts are better than IRAs in this one key area
401(k)s have a few different perks that IRAs don't offer, including the ability to have contributions taken out of your paychecks automatically as well as the possibility of earning employer matching funds if your company offers them.
But one of the biggest advantages of a 401(k) compared to an IRA is that it allows you to contribute much more money to it than an IRA does. In 2021, the IRA contribution limit was $6,000 or $7,000 if you were 50 or over and eligible for catch-up contributions. By contrast, the contribution limit for a 401(k) account was $19,500 or $26,000 if you were eligible for catch-up contributions.
The fact that the contribution limit for a 401(k) is more than three times greater than for an IRA makes it much easier to invest enough money to build the nest egg you need while earning generous tax breaks. A $19,500 contribution, for example, could save you as much as $4,290 on your taxes in total if you're in the 22% tax bracket while the maximum tax savings you'd get for a $6,000 IRA contribution in the same bracket is $1,320. The government is providing you a much larger subsidy with a 401(k).
This major benefit of a 401(k) is getting even bigger in 2022, since 401(k) contribution limits are going up but IRA contribution limits are not. The 401(k) contribution limit is increasing by $1,000 to $20,500 total, up from $19,500. While the catch-up contribution limit is staying the same, this still means that retirement savers can invest even more in their 401(k) account next year. This isn't the case for those who invest in an IRA, as the contribution limit will remain at $6,000 (and the IRA catch-up contribution limit isn't changing either).
The reality is, for many people, it's necessary to save more than $6,000 per year in order to end up with a large enough nest egg to supplement Social Security and enjoy a comfortable retirement. If you're investing in an IRA, you'll need to choose a supplementary account to save enough if that's the case for you. But if you're investing in a 401(k), the contribution limits may be high enough that you can use that as your sole retirement plan if you choose to do so -- especially with the boost they're getting in 2022.