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 offers the added bonus of reducing your adjusted gross income and lowering your tax liability for the year. A financial advisor can help you determine how much you should be saving for retirement to reach your goals.
What Is Adjusted Gross Income (AGI)?
Adjusted gross income (AGI) plays an important role in the realm of personal finance and taxation. It represents the starting point for determining an individual or household’s federal income tax liability in the United States. In essence, AGI is the sum of all your taxable income sources, with certain deductions subtracted. The lower your AGI, the less you may owe in taxes.
Your AGI is calculated by adding up all your sources of income, which may include wages, salary, self-employment income, rental income, interest, dividends and more. It’s essential to note that some income sources, like Social Security benefits, may be partially taxed, impacting your AGI.
Once you’ve added up your gross income, you can subtract certain deductions to arrive at your AGI. These deductions include contributions to certain tax-deferred retirement accounts (like traditional IRAs), student loan interest and a few others. The resulting figure, your AGI, is used as a basis for determining your taxable income.
How 401(k) Contributions Reduce Your AGI
Because traditional 401(k) contributions are made pre-tax, they get subtracted from your paycheck before taxes. This means they can lower your total taxable income, and subsequently, your AGI. And a reduction in your AGI can lead to lower taxes for that year, which could in turn increase your tax savings.
As an example, let’s say you contribute 10% of your salary to your 401(k). If you earn $60,000 per year from your job, that would mean your employer would automatically deduct $6,000 from your paychecks, lowering your AGI to $54,000.
While 401(k) contributions lower your tax liability for the year in which they’re made, you’ll eventually pay taxes on the money. 401(k) contributions simply provide you the chance to defer taxes until retirement when you’ll potentially be in a lower tax bracket.
Do Roth 401(k)s Lower Your AGI?
While 401(k) contributions can lower your AGI, Roth 401(k)s do not lower your AGI because contributions are made with after-tax dollars. However, Roth 401(k)s offer a different tax advantage as they can potentially reduce your taxable income in retirement.
Withdrawals from Roth 401(k) accounts are typically tax-free as long as certain conditions are met, such as reaching the age of 59 ½ and having the account 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 Reduce Your AGI
Aside from 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 lower your AGI, and eventually, reduce your taxable income.
Common examples of above-the-line 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 that were executed before 2018.
These deductions are available to taxpayers regardless of whether they itemize their deductions or claim the standard deduction.
Bottom Line
When it comes to tax planning, understanding how 401(k) contributions impact AGI is essential. Lowering your AGI may reduce your tax bill and could 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. Moreover, this understanding can help you make informed decisions about your retirement contributions and tax planning strategies.
Retirement Planning Tips
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Whether you’re saving with a 401(k), IRA or another type of account, it’s important to track your progress and project how much you could have in savings 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 could be worth by that time.
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A financial advisor can help you plan and save for retirement. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel 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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Source: finance.yahoo.com