Last week, the Internal Revenue Service (IRS) announced record changes to the retirement plan contribution limits that should have U.S. retirement planners excited.
All major retirement savings vehicles saw their contribution limits increase, which is a huge win for those saving for retirement. Unlike Social Security cost-of-living adjustments (COLAs), retirement account contributions are not automatically pegged to inflation -- 401(k) plans, for example, usually see a flat annual increase of $500 when there's inflationary pressure (as opposed to an increase that matches the rise in inflation).
But the result of inflation being at a 40-year high in 2022 led the IRS to implement record increases in contributions toward retirement accounts such as the 401(k), Roth IRA, and traditional IRA in 2023.
Image source: Getty Images.
The 401(k) contribution increase is the highest ever
Participants in 401(k)s will see a contribution increase of nearly 10%, as the IRS has elected to raise it from $20,500 to $22,500 in 2023. This is the highest increase to date, and most notably it's higher than inflation, which is hovering around 8.2% year to date.
The contribution limit for individuals 50 years and older (known as the catch-up contribution limit) also increased from $6,500 to $7,500. In other words, the maximum any individual can contribute to a 401(k) plan in 2023 is $30,000.
This is significant for many reasons, but perhaps none more important than the power of compounding. If you invested an extra $2,000 per year for 30 years, assuming a 10% annual rate of return, here's how much you'd have from the additional invested capital alone:
Data source: Investor.gov.
Roth IRAs also saw healthy bumps
Roth IRAs have not seen contribution raises in three years, but that will change in 2023 as participants will enjoy a $500 annual bump.
This might seem insignificant, but it's an 8.3% increase from the previous contribution limit of $6,000, and any contribution limit to the Roth IRA should be welcomed, as you have the unique ability to grow your investments tax-free.
Roth IRAs allow you to contribute earned income (after taxes) and grow it without incurring capital gains taxes, provided you follow the rules.
Let's imagine you contributed the annual maximum of $6,500 in 2023 and never added another penny. After 30 years (assuming a market-tracking return of 10%), that initial investment would be worth over $113,000.
Image source: Investor.gov
And the best part is you'd get to keep all of it because you were able to grow it tax-free in a Roth IRA.
Just for fun, let's imagine you now contributed the 2023 maximum each year for those same 30 years and assuming the same 10% annual rate of return.
Image source: Investor.gov
And here's how much you'd have if you contributed only $6,000 (last year's maximum limit) and the same 10% annual rate of return.
Image source: Investor.gov
As you can see, that $500 bump accounts for roughly $1 million in wealth over 30 years.
Retirement accounts and contributions limits might sound boring, but understanding and taking advantage of them can quite literally cost you millions of dollars in the long run.
