The IRS's 401(k) contribution increase in 2023 is a big deal. The agency recently announced an increase in the pre-tax 401(k) limit—employees can now contribute up to $22,500 of their salary towards retirement accounts each year.
This is a nearly 10% increase from the previous year's limit of $20,500. It is good news for employees—especially those planning to contribute to their 401(k) in 2023. But, it also raises some questions: What contributed to this rise? Is this an opportunity for you? If so, how can you take advantage of it?
To answer these questions, we need to look at some background information. The IRS determines the maximum amount a person can contribute to their 401(k) based on age and salary. These limits are set annually and are dependent on the cost-of-living increases.
Several limits determine how much you can contribute to your 401(k):
The elective deferral limit — This is the most crucial contribution limit. It is the maximum amount an employee can contribute to their 401(k), both pre-tax and after-tax. In 2022 this limit is $20,500. But for the year 2023, it will be $22,500.
MORE FROMFORBES ADVISOR
The catch-up contribution limit — This is the additional amount that those aged 50 and above can contribute to their 401(k). In 2022 this limit is $6,500. But for the year 2023, it will be $7,500.
The employer matching contribution limit — This is the maximum amount that an employer will match their employees' contributions. In 2022 this limit is $61,000 ($67,500 with the catch-up contribution). But for the year 2023, it will be $66,000 ($73,500 with the catch-up contribution).
Why Did the IRS Raise the 2023 401(k) Contribution Limits?
Inflation is the number one culprit for the increase in the 401(k) contribution limits. With inflation clocking highs of 8.2%- one of the largest since 2018 - it is apparent why the government feels the need to increase the contribution limits.
The government uses inflation as a benchmark to determine whether or not it should raise the contribution limits. When consumer prices rise, the IRS will increase the contribution limit for the following year by adjusting it for inflation.
This adjustment ensures that people can continue contributing more each year without worrying about losing purchasing power due to inflation rates rising faster than their salary increases or other income streams (like interest earned from investing).
Inflation is a measure of how fast prices rise. For example, if the price of bananas goes up by 5% in one year, then inflation has increased by that amount. In the US, the Consumer Price Index (CPI) measures inflation. The CPI is published monthly and tracks changes in consumer spending from one year to another based on data collected from thousands of sources.
Inflation is a fact of life. It's something you should expect to deal with in your career, and it's something that can affect your 401(k) contributions in 2023. But how?
One way is by increasing the cost of living. This means that it will take more money to maintain the same standard of living that you had before. If you have not adjusted your retirement contributions since last year, you'll have trouble keeping up with inflation.
Inflation can also affect your 401(k) contributions by increasing the tax rate. When wages and salaries rise due to inflation, more income will be taxed at higher rates than before—meaning that less money will be available for retirement savings!
Inflation can also trigger changes in contribution limits: if no adjustments are made, the caps may not keep up with new costs of living or higher taxes. Inflation isn't something anyone can easily control, but there are ways to work around it when making decisions about how much money goes into your retirement fund each year.
Should You Maximize Your 401(K) Contribution?
The answer is maybe. It's generally good to contribute as much as possible to your 401(k) account. And if you don't take advantage of this increase, you may miss out on thousands of dollars in tax savings throughout your career.
On the other hand, the quality of your current employer 401(k) plan offering is an additional consideration. For example, if the plan is expensive and loaded with hidden fees, you may want to rethink how much you are putting into it – and may be better off investing in an outside brokerage account. You can find out what the expenses are by reviewing your annual fee disclosure notice (405(a)5) or ask your HR person at work. A rule of thumb is if overall “All In” fees should be less than 1%. If it is not, contribute up to the employer match if possible.
If you're overwhelmed by saving more money, consider starting with more minor changes. For example, try adding an extra $100 per month to your 401(k) contribution and see what kind of difference it makes over time. Gradually increase your savings until you reach a point where you can set aside more money for retirement.
It’s always a delicate balance when analyzing whether you are over-committing yourself. Making sure you are keeping enough of your salary for current needs is essential before putting away money for retirement. Just make sure you are being honest with yourself on what your current “needs” really are.
Your initial goal should be to save enough to match your employer's retirement plan contribution if they offer one. If you can do that, it will be much easier to set aside more money in your 401(k) and IRA accounts.
According to Vanguard, for many it can be wise to invest 12% -15% of your annual income in retirement savings. One of the most efficient ways to reach this goal is by increasing your 401(k) and IRA contributions each year. For example, if you currently invest 7% of your salary yearly, increasing that amount by 1–2 percentage points will help boost your savings. Your consistency and discipline will pay off in the long run.
Bottom Line
In 2023, Americans will be able to contribute more money to their 401(k)s than at any point in the last 30 years.
The maximum contribution limit for 401(k)s increases from $20,500 in 2022 to $22,500 in 2023—the highest since 1985. This means that Americans can save more money for retirement than ever before.
However, there are also a few catches. This is good news for those who contribute the maximum allowed by law each year. However, for people with lower salaries or fixed incomes (such as retirees), this change may not significantly impact their savings rate's overall growth.
Additionally, if you plan to take on debt or make large purchases like cars or houses in the next five years, adding more money to your 401(k) may not make sense.
Ultimately, your financial situation will vary depending on your life stage and how much disposable income you have left over after paying all of your monthly expenses. If you're considering making additional contributions to your 401(k), it's essential to understand the full effect of these contributions on your overall financial situation.
Hopefully, you can take advantage of the opportunity to contribute more money to your 401(k) and increase your savings over time.
Brian Menickella is the founder and managing partner at Beacon Financial Services, a broad-based financial advisory firm based in Wayne, PA.
Securities and Advisory services offered through LPL Financial, a registered investment advisor. Member FINRA/SIPC.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice.
