Do IRA Contributions Lower Your AGI? - SmartAsset

The link between IRA contributions and your adjusted gross income (AGI) can get complicated because not all contributions to IRAs lower your AGI. Generally, this is one of those situations where you’ll be pleased to file a tax return with a smaller AGI because those IRA contributions will go to your retirement while also reducing your tax bill. If you’re looking for smarter tax strategies to help you with your investments and long-term retirement planning, consider working with a financial advisor.

When Do IRA Contributions Lower an AGI

Contributions to an IRA can shrink your AGI if they are going to a traditional IRA. They will not lower your adjusted gross income if they are invested into a Roth IRA. The main distinction between a traditional and Roth IRA is in how each entity is taxed. A little history may help in understanding how a traditional IRA and a Roth IRA came to be taxed differently. Traditional IRAs are called traditional IRAs simply because they have been around longer than Roth IRAs. Traditional IRAs first came into existence in the 1970s; Roth IRAs were first introduced in 1997.

Although everybody refers to an IRA as an individual retirement account, it actually stands for an individual retirement arrangement. These IRAs were created when the Employee Retirement Income Security Act of 1974 was passed by Congress. When the Roth IRA was introduced in Congress over two decades later, its big selling point was that, unlike a traditional IRA, the investment could grow over the decades, tax-free.

The reason Congress became involved in individual retirement arrangements was to give freelance workers and employees at companies that didn’t offer pension plans, a way to save for retirement. The IRAs may have been more popular than Congress intended. It has been theorized that the popularity of IRAs, not to mention 401(k) plans, has given corporations less incentive over the years to offer pension plans.

How Taxes Factor Into a Traditional IRA

As for how the two individual retirement accounts or arrangements are different when it comes to taxes, it works this way for a traditional IRA: when you put money toward a traditional IRA, those contributions will lower your adjusted gross income. In 2023, the maximum contribution will be $6,500 (although people 50 and up can do a $1,000 catch-up contribution).

So let’s say you plan to put $4,000 into your IRA in 2023, but near the end of the year, you decide to add another $2,500. Because of that decision to max out your contributions, your adjusted gross income will be $6,500 less than what it otherwise would have been – and you’ll be taxed on your adjusted gross income and not the $6,500 you put into the traditional IRA.

So if you put $6,500 into your traditional IRA in 2023 and you earn $100,000 in revenue the same year, your adjusted gross income will be $93,500. That’s the amount of revenue you’ll be taxed on. The IRS refers to this as modified adjusted gross income (MAGI).

Of course, it isn’t as if the Internal Revenue Service will never see that $6,500. When you eventually take money out of a traditional IRA to fund your retirement, the IRS will take its share of what you withdraw. But for all of those working years in which you’re funding your traditional IRA, you’re getting a smaller tax bill, which translates into more purchasing power and more money that you can put away into your retirement.

How Taxes Factor into a Roth IRA

Your adjusted gross income is not lowered if you contribute money to a Roth IRA. So if you put $6,500 into your Roth IRA in 2023 and you earn $100,000 in revenue the same year, your adjusted gross income will be $100,000. That’s what you’ll be taxed on.

But what many financial advisors and investors like about a Roth IRA is that once the money is in the account, your investment will grow without taxes ever touching the money. The earnings grow tax-free and qualified withdrawals are free and clear of taxes and penalties.

The Bottom Line

Whether you prefer a traditional IRA or a Roth IRA is more a matter of preference and perhaps a topic to discuss with a financial advisor; they’re both excellent financial vehicles for funding retirement. It’s important to fund your IRA, whether it’s a traditional or Roth, as much as possible. If you can max out your contributions, that should be the goal. If you happen to have a traditional IRA and your adjustable gross income is lowered, that’s simply icing on the cake.

Tips for Retirement Planning

When making retirement plans it is important to think through not just what assets you want in your portfolio but also how your investments might impact your taxes. A financial advisor can help you figure out both through the creation of a long-term retirement plan. If you don’t have a financial advisor, finding one 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 interview your advisor matches at no cost 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.
If you’re looking to save for retirement you should know where you stand at all times. Consider using SmartAsset’s free retirement calculator to help you see if you’re on track for the retirement you picture.