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Why are there contribution limits for IRAs or 401k?

Since I need to make this longer, I tried to look for it. This is the closest thing I've found: Why is there such disparity of max contribution limits between 401K accounts and regular IRA accounts?

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2 Answers 2

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If there were no contribution limits, you could shelter practically all of your income from income tax. The government would not have sufficient tax revenue. Hence, there are limits which ensure some personal income remains taxable today.

Similarly, when you retire, there are rules for minimum required distributions (withdrawals) which ensure the government gets to tax some of your income each year in your retirement, depending on the account type.

One other advantage of limits is to encourage people to approach saving for retirement using regular, ongoing contributions made in the context of each year's limit. The limit, in a sense, can be a form of guidance. Some aim to contribute to the limit, and some even save beyond it using plain taxable investments.

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If you sheltered all of your income from income tax this way, you would, in a rather real sense, (not just in terms of taxation) have no income. I don't see why the govt needs to prevent this: whenever you choose to withdraw the money, it's taxed. I can understand the encouragement/guidance angle, but not the rest. –  Tim S. Mar 21 at 14:14
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@TimS The government desires its tax revenues to have some level of predictability, else budgeting would be hard(er). –  Chris W. Rea Mar 21 at 18:51
    
@TimS. there is still a difference in the amount of tax collected. Consider a Roth IRA vs. a taxable account. In both cases you deposit post-tax money into the account, but only with the taxable account will you pay additional tax thereafter based on growth and dividends. –  Daniel Mar 24 at 0:19
    
@Daniel For the sake of completeness, I'll point out that withdrawals from a Roth IRA can still be taxed if you withdraw the money early (before age 59.5, or before 5 years of having a Roth IRA) and start dipping into the earnings portion (as opposed to basis). More details here. –  Chris W. Rea Mar 24 at 1:20
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Tax-advantaged accounts mean you pay less tax. You fundamentally pay less tax on IRAs and 401ks than other accounts. That's their benefit. You keep more money at the expense of the government. It makes sense for the government to limit it.

If you don't understand why you pay less tax, you must consider the time value of money -- the principal now is the same value of money as the principal + earnings later.

With IRAs and 401ks, you only pay income tax once: with Roth IRAs and 401ks, you pay tax on the entire amount of money once when you earn it; with pre-tax Traditional IRAs and 401ks, you pay tax on the entire amount of money once when withdraw it.

However, with outside accounts, you have to pay tax more than once: you pay once when you earn it, and pay tax again on the earnings later, earnings that grew from money that was already taxed (which, when considering time value, means that the earnings have already been taxed), but is taxed again. For things like savings in a bank, it's even worse: interest (which grew from money already taxed) is taxed every year, which means some money you pay tax on n times, if you have it in there n years.

If you don't understand the above, you can see with an example. We start with $1000 pre-tax wages and for simplicity will assume a flat 25% income tax rate, and a growth rate of 10% per year, and get the cash (assume it's a qualified withdrawal) in 10 years.

  • Pre-tax Traditional IRA or 401k: Start with $1000. After 10 years, it grows to $1000 * (1.1)^10 ~ $2593.74. After 25% tax, we have $2593.74 * 0.75 = $1945.31.
  • Roth IRA or 401k: Start with $1000. After 25% tax, we have $750. After 10 years, it grows to $750 * (1.1)^10 ~ $1945.31. Note that this is the same as the Traditional IRA. This is because in both cases, we pay tax on the same time value of money -- the principal at the time of contributing is equivalent to the principal + earnings at the time of withdrawal.
  • Savings account, short-term capital gains, or other income which is taxed each year: Start with $1000. After 25% tax, we have $750. Each year, we earn 10%, but pay tax on 25% of that, so we actually earn 7.5%. After 10 years, it grows to $750 * (1.075)^10 ~ $1545.77.
  • Long term capital gains:
    • if taxed at the same rate as regular income: Start with $1000. After 25% tax, we have $750. After 10 years, it grows to $750 * (1.1)^10 ~ $1945.31. Then the $1195.31 in earnings will be taxed again to leave $1195.31 * 0.75 = $896.48, for a total of $1646.48.
    • if taxed at the 15%: Start with $1000. After 25% tax, we have $750. After 10 years, it grows to $750 * (1.1)^10 ~ $1945.31. Then the $1195.31 in earnings will be taxed again to leave $1195.31 * 0.85 = $1016.01, for a total of $1766.01.
    • Capital gains would have to be taxed at 0% to match the advantage of IRAs/401ks.
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Re: "With IRAs and 401ks, you only pay income tax once" ... For the sake of completeness, I'll point out that withdrawals from a Roth IRA can still be taxed if you withdraw the money early (before age 59.5, or before 5 years of having a Roth IRA) and start dipping into the earnings portion (as opposed to basis). More details here. –  Chris W. Rea Mar 24 at 1:23
    
@ChrisW.Rea: Right, I should say I assume it is a qualified withdrawal. –  user102008 Mar 24 at 2:22
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