Do 401k contributions reduce AGI?

If your employer has a 401(k) plan, it can be an effective retirement savings vehicle to ensure a comfortable retirement. A 401(k) plan allows you to pay yourself first by making contributions towards your retirement. Once you join a 401(k) plan, you can start stashing away money for your retirement without paying taxes on it. You can let the money grow tax-deferred until when you take a distribution in retirement.

Contributions to a traditional 401(k) reduce your adjusted gross income (AGI). If you contribute to a 401(k) through payroll deductions, the employer reduces these contributions from the amount of income reported on Form W-2. For example, if you earn $100,000 and you contributed up to the IRS limit of $19,500 in 2020 and 2021, the income reported on W-2 will be $80,500.

What is AGI?

Adjusted Gross Income (AGI) is the basis for most tax deductions and credits, and the IRS uses AGI to determine your tax liability for the year. It is calculated by adding up all your incomes for the year i.e. wages, royalties, dividend income, interest income, and retirement distributions, and deducting certain adjustments to determine how much tax you will owe. The allowable adjustments may include health savings account contributions, alimony payments, 401(k) contributions, student loan interest, and early withdrawal penalties on savings. AGI determines your eligibility to claim certain deductions and tax credits.

How to Calculate AGI

When calculating AGI, start by adding up your incomes for the year, including your salary, interest income, dividends, rental incomes, profit from a property sale, and any other income reported on IRS Schedule 1 to get the total income for the year. You can deduct qualifying adjustments such as 401(k) contributions, IRA contributions, SEP contributions, student loan interest, etc. The figure obtained after deducting the allowable adjustments from the total income is the adjusted gross income. Usually, the lower the AGI, the more the deductions you are eligible to claim, and vice versa.

Do traditional 401(k) contributions reduce AGI?

Retirement contributions to a 401(k) effectively reduce your AGI. You can contribute to a 401(k) plan if your employer offers such a plan; you must also be eligible to join the retirement plan. Usually, you can contribute a portion of your paycheck up to the IRS limit, and these contributions help reduce your taxable income for the year.

For 2020 and 2021, you can contribute to a 401(k) up to the IRS limit of $19,500. Taxpayers who are 50 or older can contribute an additional “catch-up” contribution of $6,500 above the IRS limit, hence increasing the contributions to $26,000. For example, if a 52-year old employee earns $100,000 annually, they can contribute to a 401(k) up to $26,000. Therefore, the taxable income for the year will be $74,000, after taking out the retirement contributions.

A 401(k) is an attractive option for taxpayers who want to reduce their AGI. It allows taxpayers to defer paying taxes and reduce their tax liabilities. You only pay taxes when you take out money from your retirement plan in the future.

Do Roth 401(k) Contributions Reduce AGI?

A Roth 401(k) is an employer-sponsored retirement plan that is funded by after-tax dollars. This means you pay taxes when you contribute to the retirement account. Since Roth 401(k) contributions are taxed upfront, they do not reduce the adjusted gross income.

You can contribute to a Roth 401(k) up to the IRS limit of $19,500 in 2020 and 2021. Employees aged 50 or older can make an additional $6,500 in catch-up contributions.

Once you retire, you can take distributions from the Roth 401(k) account without paying income taxes. You can also take qualified distributions from the account if you have held the account for five years or more, and you have reached age 59 ½.

Do IRA contributions reduce AGI?

The money contributed to an IRA account reduces your AGI on a dollar-for-dollar basis as long as it is within the allowed contribution limits. For 2021, you can contribute up to $6,000, and an additional $1,000 if you are age 50 or older.

If you are not covered or enrolled in an employer-sponsored retirement plan, you can reduce your AGI by the full IRA contribution amount. However, if you are enrolled in an employer-sponsored plan at work, the reductions for the IRA contributions are limited.

For example, if you are a single filer enrolled in a workplace retirement plan, you can take a full deduction if your AGI falls under $66,000, or a partial deduction ranges from $66,000 and $76,000. There are no deductions for incomes above this range. If you are a married couple and the spouse is covered in a workplace retirement plan, you can deduct the full IRA contributions if the annual AGI is below $105,000. If the annual AGI ranges from $105,000 to $125,000, you can take a partial IRA deduction. If the AGI is higher than these limits, you cannot take a deduction.