Does a Roth IRA Reduce Taxable Income?

How IRA Contributions Can Reduce Adjusted Gross Income

Do IRA contributions reduce adjustable gross income (AGI)? Yes, they surely can. 

Contributions to a traditional IRA are made with pre-tax dollars and do reduce your AGI. However, contributions to a Roth IRA do not lower adjusted gross income. However, Roth IRAs can potentially reduce overall tax liability in the long term through tax-free investment growth and disbursements after age 59½ and once the account has been open for five years..

Your AGI is how much you have earned in a tax year after taking any applicable deductions. Of all of the line items on a tax return, this is among the most important. It directly relates to the amount you pay in taxes. Many people attempt to reduce their adjusted gross income because of the direct connection between AGI and tax liability.

One of the most common questions we are asked is whether or not IRA contributions are a way of lowering adjusted gross income.

The answer is yes, they can — but not always. You can contribute to an IRA to reduce taxes, but those contributions won’t always lower your AGI.

Let’s see how and why.

Do IRA Contributions Reduce AGI?

You can make contributions to an IRA with pre or post-tax dollars, depending on the type of IRA you have. If you elect to use pre-tax dollars, as with a traditional IRA, you reduce your AGI. How? By deferring taxes on the income until withdrawal. 

At that point, the money will be included in your taxable income. An IRA deduction works by subtracting contribution amounts from your AGI.

How much of a tax deduction is an IRA contribution? The exact amount of tax savings depends on your specific situation. You could potentially reduce AGI by as much as your total contributions, but some restrictions apply. How much an IRA saves on taxes depends on your contributions, income level, other retirement plans, and more.

You must have earned income to contribute to an IRA. If you are enrolled in a retirement plan through your work, you may be unable to deduct IRA contributions. That’s true if you make above $73,000 as a single filer or $116,000 if you’re married and filing jointly. There is no income limit to making a nondeductible traditional IRA contribution.

What if you do not work, but your spouse does? You may be able to contribute to your IRA if your total modified adjusted gross income is within the IRS limits.

Do Roth IRA Contributions Reduce Taxable Income?

A Roth IRA is funded with post-tax dollars. Therefore, it does not reduce your AGI. Investments grow tax free and there are no taxes on qualified withdrawals. 

This may be appropriate for individuals who are in a lower tax bracket now than they expect to be at the time they withdraw their funds. One example is people at an early stage in their careers. 

Does a Roth IRA lower your taxable income? It won’t help reduce AGI or tax liability in the years when you make contributions. However, it will can provide tax-free growth and, when the time comes, qualified distributions as well.

Traditional IRA vs. Roth IRA

A traditional individual retirement account (IRA) is funded with pre-tax dollars. Taxes are paid at the time of withdrawal. How does an IRA lower your taxes? By counting contributions made as reductions of your AGI.

Roth IRAs are funded with after-tax money. As mentioned, funds grow tax free and qualifying withdrawals are not taxed. This may be appropriate if you are presently in a lower tax bracket, like when you are early in your career.

What’s The Difference?

Traditional IRA contributions are made with pre-tax dollars. Therefore, they do reduce your AGI (in most cases). However, you will pay taxes when you withdraw the funds at retirement.

Roth IRA contributions are not tax-deductible, and therefore do not reduce your AGI. Similarly, a Roth IRA does not reduce taxable income in years when you make a contribution. However, there are no taxes on investment growth or withdrawals in retirement (i.e. after you turn 59 ½) and you’ve had the account for over five years.

Pros and cons of Traditional IRAs

There are several benefits to the traditional IRA. As with all financial products and investment vehicles, though, it isn’t without limitations and drawbacks, too.

Pros:

• Reduced AGI and, therefore, tax liability in years when contributions are made
• Deductible contributions
• Growth is tax-deferred
• Available in addition to existing employer-sponsored plans

Cons:

• Hefty early withdrawal tax and penalties of 10% before age 59 1/2
• Lower contribution limits than 401k
• Undeterminable tax rate, as you are taxed at your tax rate at the time of withdrawal
• Required minimum distributions beginning at 72

Pros and cons of Roth IRA

Let’s also review the pros and cons of the Roth IRA.

Pros:

• Tax-free growth of your investments
• You can withdraw your contributions at any time without being penalized
• You do not need to take required minimum distributions at any time
• Withdrawals are not subject to taxes or penalties, if they are qualified
• Contributions to Roth IRAs may be withdrawn anytime without penalty; taxes and penalties are only assessed before age 59 1/2 on withdrawn earnings

Cons:

• Taxes are paid upfront
• Contributions do not lower your AGI
• Roth IRA’s have income limits; you cannot open a Roth if you earn over $140,000 as a single filer or $208,000 if married filing jointly
• Are Roth IRA contributions tax deductible? Not generally.

2023 IRA Contribution Limits

In 2023, the contribution limit is $6,500 per year unless your income is below $6,000. In that case, you cannot contribute more than you earn. 

Individuals age 50 or older are eligible for catch-up contributions. These raise the contribution limit to $7,000 per year.

Additional Ways to Lower AGI

Contributions to a traditional IRA are one way to reduce your AGI. It isn’t the only option, however.

Let’s take a look at some short-term and long-term opportunities to reduce your AGI. Even more in-depth approaches can be found in our guide to high-earner tax reduction strategies.

Short-term Strategies to Reduce AGI

Tax- Loss Harvesting

The idea behind tax-loss harvesting is simple: sell certain investments at a loss to offset your taxable gains on other investments.

When you have stocks that you are ready to sell, even though it is at a loss, this will reduce your net profit. As a result, you effectively reduce your tax liability.

Charitable Donations

Donating funds to a charitable organization provides an opportunity to reduce your taxable income.

There are limitations on what can and cannot be deducted from taxes. For example, you cannot deduct the value of the time you donate to a charity.

To maximize your deduction, be sure to itemize deductions if they exceed the standard deduction. If you do not, your charitable contributions surely won’t be in vain, but they may not result in any tax savings at all. A strategy to consider if you’re over the age of 72 is called a qualified charitable distribution or QCD.

Long-Term Strategies to Reduce AGI

Health Savings Accounts

Putting money into an HSA can help you save for future medical expenses when they happen. These are funded with pre-tax dollars, so they can lower your taxable income by reducing your AGI.

Want to know another way to leverage an HSA?

Don’t withdraw from it.

You don’t need to request reimbursement from your HSA at the time of the medical expense. You can be reimbursed anytime. By deferring your reimbursement, you allow your contributions to grow tax-free.

Hire your Child

If you own a business, especially one with pass-through income like an LLC, hiring your child is an important consideration. This is a way to reduce your AGI while setting your child up for success.

Make sure your child is providing a legitimate service, but you can get creative with this. The work they can do will depend on the business you operate. However, even young children can provide valuable contributions to a company by handling mail, filing paperwork, acting as a model for marketing material, and more.

Are you ready for the exciting part?

If your child is earning income, they are eligible to make contributions to a Roth IRA. Since their earnings will likely be low compared to their future earnings, they will pay very little tax and have an opportunity to begin saving for retirement early.

Summing It Up: Taxable Income, AGI, and IRAs

Do IRA contributions reduce your AGI?

Yes! Contributions to a traditional IRA are made with pre-tax dollars and do reduce your AGI (under most circumstances). However, contributions to a Roth IRA do not reduce AGI.

Do Roth IRA Contributions Reduce Taxable Income?

Roth IRA contributions are made with post-tax dollars and do not reduce your taxable income. However, they can provide tax benefits in the future, because investment growth and disbursements are provided tax-free under qualified conditions.

Are Roth IRA Contributions Tax Deductible?

Not generally. However, low and moderate earners who qualify for the Savers Credit may be eligible for a tax credit of 10-50% of their Roth IRA contributions.

Contributions to a traditional IRA are just one way to reduce your AGI. Many potential options are available.

There are plenty of smart strategies you can employ when it comes time for filing taxes. Take advantage of these short and long-term approaches to keep more money in your pocket year after year.Ready to learn more about potential tax savings? Contact us today!