I know what you’re thinking. “Yay! The IRS raised the limit for 401k contribution limits! Now I can put more money into that sweet, sweet tax-advantaged retirement account because I’m a responsible adult that can delay instant gratification and I like to plan ahead.”
Yes, I know all of you are thinking just that.
Unfortunately, I’ve got bad news for you. The IRS isn’t doing this as an act of generosity. No, the IRS is basically saying that your money is now worth less than it was before. So to adjust for this, it’s raising how much you can contribute. Bummer, huh?
We’ve been in a period of low inflation for many years now, so it’s not top of mind for many people. But inflation means the prices you pay for every day goods are increasing every year. As a result, your purchasing power decreases, since your dollar doesn’t buy as much as it used to. This is why old people like me are always talking about how we used to buy a bottle of coke for a nickel. Or how for a dollar you could hail a horse-drawn carriage (Uber back in the 1800’s) to get your typewriter fixed (a computer without all the functionality).
For the past 10 years, inflation has averaged under 2%. This is why it’s not a big deal now. Some of you may be too young to remember this, but inflation used to be much higher in the past. Back in 1981, inflation was running above 10%! Just think – you needed a 10% raise every year just to maintain your spending power. Back in the 80’s, I remember owning bonds that yielded 7-8%. That sounds phenomenal today. But inflation was much higher back then, so it was only modestly better than inflation.
To get a sense of how bad inflation can wreck an economy, we can look at Zimbabwe. Zimbabwe has been going through hyperinflation for some time now. Last year, Zimbabwe actually had a trillion-dollar note. Being a trillionaire sounds pretty cool, ignoring the fact that it was only worth $0.40 at the time the news article came out.
Venezuela is a more recent example of a country experiencing hyperinflation. Everybody in the country is a bazillionaire. Except it doesn’t mean much when you need to carry blocks of bills just to buy bread. Even though their currencies are basically worthless, you have to admit it looks pretty badass walking around with suitcases filled with cash.
Real and Nominal Rates
Whenever I look at my retirement accounts, it always projects that I’ll be a bazillionaire when I retire! Why does it do that? I honestly have no idea, because the numbers don’t make any sense. Maybe it thinks I’m a genius investor? One thing I know it doesn’t take into account is inflation. Assuming 3% inflation, something that costs $10,000 today will cost $32,600 40 years from now. If you’re 25 today and planning to retire when you’re 65, everything could cost 3x more! Kind of makes you re-think how much you’ll actually need when you retire, doesn’t it?
This is why when you’re estimating your investment returns, you can’t just look at the nominal return. The nominal rate is your actual return. If your 401k goes up 7% in a year, your nominal return is 7%. If inflation is running at 3%, then your real return is 4%. 4% is nothing to sneeze at on a real basis, but inflation basically cut your estimated return in half!
How Do I Fight Inflation?
That’s actually the Fed’s job, but I’m glad you’re taking a proactive approach. There are two ways to combat inflation. I’ll let you decide which one option you think is best.
Spend It All!
A dollar today will be worth less in the future. That’s a fact. By holding and saving that dollar, your purchasing power decreases. So you might as well spend it now! Why wait for the Bimmer to get more expensive next year? Buy it today! You laugh, but this strategy actually makes sense in certain cases. In countries like Venezuela, I’ve heard of some people stocking up on Bimmers. Hyperinflation means your money will be worth less tomorrow. A car is actually a better store of value in this case, even with the depreciation. Besides, you also get utility out of the car and look cool while doing it. Note, you would also get utility out of owning a Corolla, but you definitely won’t look as cool.
Make Sure Your Investment Returns Exceed Inflation
If your investments can grow above the rate of inflation, you’re all set. This is why I recommend investing in the stock market. Over time, it has consistently generated returns well above inflation. Since 1998, the S&P 500 has returned over 7% annually, including dividends. This compares to average inflation of 2% over the same time period, or a 5% real return.
In the past, I’ve talked about how you should have an online savings account. I say that because it offers the highest yields of any savings accounts. Right now, you can get up to 1.3% yields. However, you’ll notice that inflation is currently running above this rate. So if you put all your money in an online savings account, your purchasing power would still be decreasing, although at a much lower rate than if you put that cash under your mattress.
You need a certain amount of liquid assets, such as emergency savings. Or funds you plan on investing, or cash you need for a large purchase, like a down payment for a home. These funds should go into an online savings account because there’s no risk and you can pull the money out at any time. But for everything else, it needs to be in a higher yielding asset to generates returns above inflation.
How Inflation Impacts 401k Contribution Limits
Below is a table with historical 401k contribution limits. I’ve also included the CPI index and inflation rates, courtesy of the Minneapolis Fed. Back in 2015, 401k contribution limits were $18,000. In 2018, contribution limits are increasing to $18,500. This is a 2.8% increase from 2015 levels, yet inflation has gone up about 3% in the same time period. Basically, the entire increase in 401k contribution limits can be attributed to inflation.
In 1998, the maximum contribution was $10,000. According to the CPI index, everything costs about 50% more now. This means you now need a $15,000 contribution today to equal a $10,000 contribution back then. So over a longer time period, the IRS has thrown us a small bone, but it’s much smaller than most people realize.