Do IRA contributions reduce average gross income (AGI)?
IRA contributions to a traditional IRA reduce the IRA AGI or adjusted gross income because the qualifying contribution is deducted from the AGI. On the other hand, the IRA AGI for a Roth IRA is not reduced, because the contributions are funded with after-tax dollars. Any investment gain is also tax free. When the money is withdrawn at retirement, the amount is not taxed.
Therefore, the money that is deposited into a traditional IRA is deducted from the depositor's AGI, which gives the account holder a tax break on the currently funded amount. Taxes are only owed at the time of withdrawal on a traditional IRA account.
The IRS places limits on the amount you can invest annually in an IRA. As of 2014, the IRA limit for contributors is $5,500 plus a $1,000 catch-up contribution for taxpayers who are 50 years old and over.
Holders of IRAs are not permitted to withdraw funds for retirement until they turn 59.5 years old. All the funds in a traditional IRA account must be withdrawn by the time an account holder is 70.5 years old. The age limit is not capped for withdrawing funds for holders of Roth IRA accounts. You can take out the money at any time after you turn 59.5. Funds withdrawn for retirement before age 59.5 are subject to a penalty of 10% plus and taxation.
As of 2014, a full deduction of an IRA investment is permitted if your AGI as a single filer is under $60,000 per year or below $96,000 annually as a joint filer. A partial deduction is allowed for single filers making $60,000 to $70,000 per year and joint filers who make up to $116,000 annually. Deductions are not available for people making over $70,000 as a single filer or above $116,000 annually as a joint filer.
If it is tax deductible traditional IRA, subject to limitations if you have an employer plan, the contribution WILL reduce your Adjusted Gross Income (AGI) by $5,500 (or $6,500 if you are older than age 50 due to the make-up contributions allowable). If your income is too high or if you have an employer plan, your contribution may NOT be deductive and therefore would not reduce your AGI. Also, a Roth IRA will NOT reduce your AGI as it is not deductible.
Whether a Roth vs. Traditional are better for you, it can depend on many factors such as current income tax brackets, retirement expected tax brackets or other assets that you may have (due to possible penalties if you retire earlier than age 59 1/2.
The most attractive features of IRAs are the deductibility of contributions and the tax-free growth potential of assets once they're in the account. If you earn too much, then the deductibility feature of your contributions goes away and your AGI isn't reduced. If this is the case, then an investor can still make a contribution to an IRA, but that contribution isn't deductible to their income. In this case, an investor should consider performing an immediate Roth IRA conversion so that the funds maintain that same tax-free growth potential as an IRA, but eventual withdrawals from the account are tax free. This process is also referred to as a Backdoor Roth IRA.
Of course, these are complicated processes and your advisor network should be consulted prior to implementing any tax or investment strategy.
Adam C. Harding, CFP
I think what you meant AGI means “Adjusted Gross Income” as the reduction of an IRA contribution is an adjustment to your gross income.
Your contribution to a traditional IRA may or may not give you that deduction. If you don’t have any work sponsored retirement plan, regardless of your income, you can fully deduct the contribution. For example, you make $1 million dollar a year, but your employer does not provide any retirement plan, such as the 401k, you can fully deduct that $5,500 contribution to the IRA ($6,500 if you’re age 50+).
On the other hand, if your employer offers a retirement plan, SIMPLE, SEP, or 401k, but your income as a “Single” or “Head of Household” filing status is below the threshold of $62k in 2017, you can once again deduct that $5,500 contribution. Once your income is above $72k, you are completely phased out, which means you can’t deduct a penny.
The last scenario is if you’re married and your spouse may participate his/her work sponsored retirement plan. Should that be the case, your phase-out range is $186k-$196k in 2017. As long as your income is below $186k, you may still deduct the full contribution. Best!
Unless the IRA contributions are non deductible, they do reduce AGI. That is why deductible IRA contributions are considered above the line deductions. A tax forecast would help determine the deductiblity of contributing.
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The simple answer is yes. As long as they are tax deductible then yes if it is a Traditional IRA (not a Roth). The only reason it wouldn't be tax deductible is if you are also contributing to a 401k and you income is high enough to phase you out of the deduction.
Hope this helps and best of luck, Dan Stewart CFA®