In 2023 You'll Be Able to Contribute More to Your 401(k)

The 401(k) limits are increasing with inflation, and it could be a great time to boost your contributions.

Every year, the IRS determines how much can be saved in tax-advantaged retirement accounts like 401(k)s. The reason is to allow savers to increase their contributions over time to keep pace with inflation.

In 2023, the 401(k) contribution limit for elective deferrals (money you choose to contribute from your paycheck) is increasing sharply, due to inflation hovering near a 40-year high. The limit is increasing by nearly 10%, from $20,500 to $22,500, for the 2023 tax year, and there are a few good reasons you might want to take advantage of the increase -- or at least increase your contribution rate.

Inflation is a wealth-killer

First off, one reason you might want to consider increasing your retirement contributions is the same reason the limit went up in the first place: inflation.

In simple terms, inflation decreases the buying power of your money over time. If the inflation rate is 10%, this means the money in your 401(k) has 10% less buying power than it did a year ago. To be sure, the investment funds in your 401(k) have a high probability of outpacing inflation over time, so one of the best ways to fight inflation in your savings is to set aside as much as possible.

Investing in a bear market is a smart move for long-term savers

Perhaps the most compelling reason to increase your retirement savings -- and the top reason I'm planning to increase my own retirement savings in 2023 -- is the current state of the stock market.

If you've checked your 401(k) statement recently, or have watched the financial news, you know that the stock market hasn't exactly had a great year in 2022. The benchmark S&P 500 index is about 18% lower than where it started the year, and many individual stocks and market sectors have done far worse.

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However, this has historically been an excellent environment for long-term investors to put their money to work. For example, if you had invested in an S&P 500 index fund when the market first dropped by 20% in the 2008 financial crisis, you would have achieved a total return of 320% -- more than quadrupling your money -- in the 14 years since then.

How much should you be saving for retirement?

Last but certainly not least, it's a smart idea to take a step back and determine if you're saving enough of your income to help fund your retirement. If not, it could be a great idea to increase your contribution rate in 2023.

How much should you be saving? Of course, it isn't practical (or necessary) for many people to completely max out their 401(k) contributions. For example, if you earn $75,000 per year, setting aside $22,500 in your retirement account might not leave you with enough money for your living expenses.

That said, most financial planners (myself included) suggest that a good target is setting aside 10% of your income, not including any employer contributions. You don't need to get there right away -- increasing your contribution rate by even 1% of your salary can have a big impact. But if you aren't quite at the 10% level, now could be a smart time to narrow the gap, especially considering the effects of inflation and the current stock market environment.