When it comes to saving for retirement, 401(k) plans are a popular choice for many American workplaces. Contributing to a 401(k) not only helps you save for retirement but it also offers the added bonus of reducing your adjusted gross income and your tax liability for the year. A financial advisor can help you determine how much you should save for retirement to reach your goals.
What is adjusted gross income (AGI)?
Adjusted gross income (AGI) plays an important role in the field of personal finance and taxation. It represents the starting point for determining the federal income tax liability of an individual or family in the United States. In short, AGI is the sum of all your taxable income sources, minus certain deductions. The lower your AGI, the less taxes you pay.
Your AGI is calculated by adding up all of your sources of income, which can include wages, salaries, self-employment income, rental income, interest, dividends, and more. It’s important to keep in mind that some income sources, such as Social Security benefits, may be partially taxed, which may affect your AGI.
Once you add up your gross income, you can subtract certain deductions to arrive at your AGI. These deductions include contributions to certain tax-deferred retirement accounts (such as traditional IRAs), student loan interest, and a few others. The resulting figure, your AGI, is used as the basis for determining your taxable income.
How 401(k) Contributions Lower Your AGI
Because traditional 401(k) contributions are made pre-tax, they are deducted from your pay before taxes. This means they can reduce your total taxable income and, subsequently, your AGI. And a reduction in your AGI can result in lower taxes for that year, increasing your tax savings.
As an example, let’s say you contribute 10% of your salary to your 401(k). If you make $60,000 a year from your job, that means your employer will automatically deduct $6,000 from your pay, reducing your AGI to $54,000.
While 401(k) contributions reduce your tax liability for the year in which they are made, you will ultimately have to pay taxes on the money. 401(k) contributions offer you the opportunity to defer taxes until retirement when you’ll potentially be in a lower tax bracket.
Does a Roth 401(k) reduce your AGI?
While 401(k) contributions can reduce your AGI, Roth 401(k)s do not reduce your AGI because contributions are made with after-tax dollars. However, Roth 401(k)s offer a distinct tax advantage because they can potentially reduce your taxable income in retirement.
Withdrawals from Roth 401(k) accounts are generally tax-free as long as certain conditions are met, such as reaching age 59 ½ and the account being open for at least five years.
This can be a valuable tax benefit in retirement, as it allows you to access your savings without increasing your taxable income.
Other Ways to Lower Your AGI
Besides 401(k) contributions, there are several other ways to reduce your AGI. The IRS allows you to claim certain “above the line” deductions on your income tax return that can reduce your AGI, and ultimately, reduce your taxable income.
Common examples of the above deductions include contributions to traditional individual retirement accounts (IRAs), student loan interest payments, the deductible portion of self-employment taxes, as well as out-of-pocket education expenses for kindergarten through grade 12 teachers. , The IRS also allows you to deduct alimony payments made under divorce or separation agreements executed before 2018.
When it comes to tax planning, it’s essential to understand how 401(k) contributions affect AGI. Lowering your AGI can lower your tax bill and increase your eligibility for various tax benefits. Keep in mind that contributions made to pre-tax 401(k) accounts will reduce your AGI in a given year, but Roth 401(k) contributions will not. Additionally, this understanding can help you make informed decisions about your retirement contributions and tax planning strategies.
Retirement Planning Tips
- Whether you’re saving with a 401(k), IRA or another type of account, it’s important to track your progress and estimate how much you might have saved by the time you retire. SmartAsset’s retirement calculator can help you estimate how much you’ll need in retirement and what your nest egg might be worth by that time.
- A financial advisor can help you plan and save for retirement. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with three verified financial advisors serving your area, and you can have a free introductory call with one of their advisors to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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