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Commentary

Why Are IRA Limits So Much Lower Than Those for 401(k)s?

It's not as crazy as it sounds, but the answer won't make you happy.

One of the questions I hear most frequently from colleagues is: Why are IRA limits so much lower than those for 401(k) plans? There is actually a good answer, but it never leaves people feeling good about our retirement system.

To be clear, the difference in the limits is unfair: People lucky enough to have a plan at work can contribute $19,000 in 2019 to fund their retirement, while those without a plan can only contribute $6,000. That doesn't even include the employer match (if there is one), which further increases the assets that workers with a 401(k) can save each year.

However, that unfairness is a feature not a bug of the U.S. retirement system. Policymakers believe it is necessary to maintain this unfairness because extra tax incentives induce employers to offer a retirement plan when they otherwise might not. The delicate balance of incentives in the retirement system require 401(k)s to be more attractive than IRAs. At least that's what Congress, which writes the Internal Revenue Codes, believes, and the theory has never been tested since the gap has existed for 40 years since the creation of the 401(k).

So, here is the logic behind making 401(k)s much more attractive than IRAs in more detail. Without this gap in tax benefits, many employers would not feel like they needed to offer a plan. Particularly if the decision-makers at a company and higher-paid employees could get the same benefits outside of a 401(k), they would be less interested in it as a benefit. (I'm assuming that, as is the case today, higher earners would not be able to deduct their contributions to an IRA if they had a plan at work.)

If employers abandoned the system because Congress lessened the benefits of the 401(k) compared with an IRA, that would be a bad outcome for most workers--at least if everything else stayed the same. Our whole system is based around saving for retirement at work. Doing so is the main way for workers to access a well-designed investment lineup and put aside money with every paycheck without any friction. Further, auto-enrollment has helped many workers start saving without having to make any decisions.

Moreover, employers often offer a match either because their workers expect it or to avoid running afoul of fairness requirements (called top-heavy and nondiscrimination rules) that prevent the plan's benefits from accruing to a privileged few. If policymakers disincentivized offering a retirement plan, that would kill matches for lots of ordinary workers.

Armed with this answer, I have never been able to convince anyone that the gap between IRA and 401(k) tax benefits is salubrious. Who wants to tell someone that their options to save for retirement are deliberately worse in the hopes it will inspire more employers to offer a plan or at least keep the ones who do from giving up on them?

So, what can be done? The main options are to get more people in employer-sponsored plans or to completely delink retirement from employers. Of the two, getting more people into employer-sponsored plans is the most incremental and likely to succeed approach, but nothing is imminent. Rep. Richard Neal's proposals to require most employers to offer plans could help, but that's an idea that is a long way from passing and comes with real costs for employers. In-between policies, such as the Simple IRA, that have higher contribution limits than IRAs but lower limits than 401(k)s while allowing some employer contributions have had modest success.

In sum, by building our system on tax incentives, we have put ourselves in a position where making the system fairer could have the unintended consequence of pulling the rug out from ordinary workers with good 401(k) plans. At least for the moment, we are going to have to live with a system that makes a hard situation for people without a plan at work even harder. It may not be fair, but this gap is not a capricious policy. It is an intrinsic part of a voluntary system that relies completely on employers to react to tax incentives.