Why are IRA, Roth IRAs and 401(k) contributions limited?

Contributions to IRA, Roth IRA, 401(k) and other retirement savings plans are limited by the IRS to prevent the very wealthy from benefiting more than the average worker.

Contributions to traditional IRA and 401(k) accounts are made with pretax dollars, so they can offer a significant reduction to a worker's annual income tax burden. The contributions to many retirement savings accounts are capped to ensure that those who can afford to defer large amounts of their compensation do not take advantage of this tax benefit.

In 2017, the maximum employee contribution to a 401(k) plan, either traditional or Roth, is $18,000. Also, employers can contribute through either non-elective deferrals or contribution matching. However, the total contribution from all sources must not exceed the lesser of the employee's compensation or $54,000 for 2017.

To encourage those nearing the end of their working years to contribute more, the IRS also allows additional catch-up contributions for employees over the age of 50. In 2017, the catch-up contribution is $6,000, for those over 50.

A 401(k) is a qualified retirement plan offered through an employer. The IRS imposes certain limitations on the contributions of highly compensated employees, called non-discrimination testing, to encourage equal participation across all compensation levels.

For the 401(k) plan to retain its qualified status, contributions made by employees who earn large salaries – more than $120,000 must not exceed a certain percentage of the average contribution made by non-highly paid employees. This prompts higher-level employees, such as executives and management, to encourage plan participation among the rank and file. As the average regular employee contribution increases, the amount that more highly compensated employees are allowed to contribute increases, up to the annual maximum.

For the 2017 fiscal year, IRA participants are limited to a maximum contribution of $5,500, or 100% of their compensation, whichever is lesser. Those over 50 can make catch-up contributions of up to $1,000 annually.

Like 401(k) plans, the contribution limits for IRAs apply to all accounts held by the same person. If you have both a traditional IRA and a Roth IRA, the total of all your contributions to both accounts cannot exceed $5,500, or $6,500 if you are over 50.

IRAs are not qualified retirement plans because they are not offered through an employer. There is no provision for the type of non-discrimination testing that applies to 401(k) contributions.

However, IRAs were developed to encourage the average worker to save for retirement and not as another tax shelter for the rich. To prevent unfair benefit to the wealthy, the amount of your contribution to a traditional IRA that is tax-deductible may be reduced if you or your spouse is covered by an employer-sponsored plan, or if your combined income is above a certain amount.

In addition, Roth IRAs are only available to those who meet certain income requirements. In 2017, the contribution limits for single persons who earn more than $118,000, and married couples filing jointly who earn more than $186,000, are reduced. Individuals who earn more than $133,000 and couples who earn more than $196,000 are not eligible to contribute to Roth IRAs.