Retirement savings is a crucial part of financial planning, and many people opt for Individual Retirement Accounts (IRAs) to save for their retirement. However, when it comes to taxes, it’s important to understand how your contributions to an IRA can impact your adjusted gross income (AGI). While both traditional and Roth IRAs offer tax benefits, they work differently and can have different effects on your AGI. Consider consulting with a professional financial advisor if you wish to learn about IRAs, how to open one, its eligibility criteria, contribution limits, and more.
This article explores how IRA contributions can affect your AGI. Read on to learn more about IRAs, and what effect does AGI have on your retirement corpus.
What is an IRA?
An Individual Retirement Account (IRA) is a popular type of retirement savings plan in the United States that allows individuals to secure their financial future during retirement. IRAs offer tax advantages to encourage saving and can be opened with a bank, a broker, an investment firm, a mutual fund house, or an online brokerage. There are primarily two types of IRAs – traditional and Roth.
Traditional IRAs offer tax-deferred contributions, which means that the money you contribute can be deducted from your taxable income for the year, and the funds in your account grow tax-free until you begin withdrawing them, at which point you will have to pay taxes.
Roth IRAs, on the other hand, use after-tax funds, so the contributions are not tax-deductible, but the money in the account grows tax-free, and withdrawals are also tax-exempt provided you meet certain conditions i.e. you must have held your account for at least 5 years and be of 59.5 years of age at the time of making a withdrawal. Both traditional and Roth IRA have the same contribution limits. For 2022, the contribution limit was $6,000, with an additional $1,000 allowed for those over 50. In 2023, the limit has been increased to $6,500, with the same $1,000 additional contribution allowed for individuals aged 50 and up. It’s important to note that these limits apply to all of your IRAs, not just one account.
What is AGI?
Annual gross income (AGI) refers to the total amount of money a person earns in a year before any deductions or taxes are taken out. It includes all sources of income, such as wages, salaries, tips, commissions, bonuses, and self-employment income.
Adjustments to gross income, also known as above-the-line deductions, are expenses that can be deducted from your gross income to arrive at your adjusted gross income (AGI). These adjustments can reduce your taxable income, which can lower the amount of tax you owe. Some common adjustments to gross income include contributions to retirement accounts, alimony payments for divorces filed before Jan. 1, 2019, student loan interest deduction, early withdrawal charges in saving plans, educator expenses, employee business expenses for selected groups, deductions under Health Savings Account (HSA), moving expenses for armed forces members, as well as pension savings, health insurance deductions, and employment tax for self-employed individuals.
There are several other adjustments to gross income that may be applicable depending on your individual circumstances. AGI is an important measure of your financial situation because it determines how much of your income is subject to taxes. It is also used to determine your eligibility for certain programs and benefits. The Internal Revenue Service (IRS) also uses a modified version of AGI called modified adjusted gross income (MAGI), which is calculated by adding back certain deductions, such as losses in specific types of partnerships or foreign-earned income.
Understanding and properly calculating AGI and MAGI can help you make informed financial decisions and potentially lower your tax burden.SPONSORED WISERADVISOR
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How does a traditional IRA affect AGI?
It is crucial to understand how your IRA contributions can affect your adjusted gross income (AGI).
While contributions to both traditional and Roth IRAs can reduce your taxable income, only contributions to traditional IRAs will lower your AGI. This is because traditional IRAs offer tax-deferred contributions, while Roth IRAs use after-tax income. Therefore, contributions to a traditional IRA can be deducted from your gross income to arrive at your AGI, while Roth IRA contributions do not affect your AGI.
For example, let’s say you decide to contribute $2,000 to your traditional IRA for the year. Later on, you decide to contribute an additional $2,000 to your account. In this case, since your contributions are tax-deductible in nature, you would be eligible for a tax deduction of $4,000. So, if your total income for 2023 is $50,000, your adjusted gross income (AGI) would be $46,000 ($50,000 – $4,000) and would be subject to tax. In other words, the IRA contributions would reduce your AGI by $4,000.
It is important to note that you will pay taxes when you eventually withdraw your IRA funds. However, the tax benefits you receive will allow you to set aside more money for retirement or you can invest it to earn additional income. Also, remember the IRS has different rules for determining whether you are eligible for a full or partial deduction for traditional IRA contributions based on your adjusted gross income (AGI) and whether a workplace retirement plan covers you or your spouse.
In 2023, individual taxpayers can take a full deduction for traditional IRA contributions if their AGI is less than $73,000, and a partial deduction is allowed if their AGI is between $73,000 and $83,000. For married couples, if either spouse is covered by a workplace retirement plan, they can take a full deduction if their AGI is less than $116,000, and a partial deduction is allowed if their AGI is between $116,000 and $136,000.
Does a Roth IRA affect your AGI?
Contributions to a Roth IRA do not affect your adjusted gross income (AGI) because they are not tax-deductible. In other words, Roth IRA contributions do not reduce the amount of your income subject to tax. In the same example as above, if you contribute $4,000 to a Roth IRA in a given year and your total income for that year is $50,000, your AGI would still be $50,000, and you would be taxed on that full amount.
Contributions to a Roth IRA do not provide an immediate tax benefit as traditional IRA contributions do, but they can offer tax-free growth and tax-free withdrawals in retirement.
It is important to understand how your IRA contributions can affect your adjusted gross income (AGI) and, in turn, impact your taxes. Traditional IRA contributions can lower your AGI and provide an immediate tax benefit, while Roth IRA contributions do not affect your AGI but offer the potential for tax-free growth and tax-free distributions in retirement. Take into account your financial goals and tax situation when deciding which type of IRA is right for you. You can also consult with a financial advisor to explore different options and determine the best approach for your unique financial situation. Regardless of which type of IRA you choose, consistent saving and careful planning can help you build a strong foundation for your financial future.
If you’re unsure of whether IRA contributions can help lower your AGI or not, consider hiring a financial advisor that can help. Use the free advisor match tool to match with experienced financial advisors who can guide you effectively on portfolio rebalancing. Answer a few questions based on your financial needs, and the match tool will help connect you with 1-3 financial advisors that may be suited to help you.
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