In the last couple of months I have had to explain this simple fact to posters that are otherwise very well-informed in retirement savings. Instead of rehashing the information, I thought a dedicated thread would be a more convenient way to settle this issue.
IRA and 401(k) are the same for our purposes, so to make it short I will discuss exclusively the IRA.
As you know, both the Traditional and the Roth allow 5.5k contribution a year. Well, 5.5k is 5.5k, but what makes the limits different is the tax feature of the contribution.
In a Traditional, you contribute pre-tax. So let's say your monthly salary is 5.5k, then you'll be able to contribute this entire amount into a Traditional and be done for the year.
In a Roth, you contribute post-tax. So if your monthly salary is 5.5k, you have to pay income taxes before contributing. Let's just say the tax is 1.5k, so the income available for Roth contribution is 4k. If you dedicate your first month of salary to IRA contributions, you actually have not reached the limit yet. You still have a 1.5k space to fill from next month's salary.
All right, so why does this distinction matter?
As you know, money in a Traditional is taxed when withdrawn. So even though the Traditional contribution looks bigger given the same pre-tax income, it really is the same, as the Roth contribution. Assuming that the tax bracket is the same at contribution time and withdrawal time, the 5.5k Traditional contribution will be worth the same as the 4k Roth contribution. Why? Because, to put it simply, in a Roth tax is collected up front, and in a Traditional tax is collected later, but if the tax rate does not vary, a 5.5k pre-tax income dedicated to IRA contribution is going to take you to the exact same place, regardless of whether you contributed in the Trad style or the Roth style. If you don't understand the logic, hopefully some math will clarify.
To make numbers round, let's say between contribution time and withdrawal time your portfolio has grown 10 times.
To simplify matters, the income tax rate is assumed to be the same at these two points in time. Since 5.5k pre-tax becomes 4k post-tax, the tax rate is 1.5k/5.5k or 3/11.
So if you contributed 5.5k to Trad, you'll have 55k pre-tax at withdrawal. The income tax on the withdrawal is 55k*3/11=15k. So post-tax, you end up with 40k.
If you contributed 4k to Roth, you'll have 40k post-tax.
So 5.5k contribution to Trad means the same as 4k contribution to Roth. This means that any extra contribution you can make to the Roth is going to earn you additional tax advantage. In other words, for the purpose of contributing to tax-advantaged retirement accounts, the Roth gives you a higher contribution limit.
Does this all make sense? Please share your questions/comments/thoughts on this.