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Do 401(k) Contributions Reduce Earned Income Credit?

Original post by Angie Mohr of Demand Media

The earned income credit (EIC) is available for employed and self-employed taxpayers with low income. Several factors affect the amount of the credit available and the credit disappears when income reaches a maximum amount that is set by the IRS annually. Contributions to 401k plans do not reduce the EIC, but, rather, can increase it.

The Basics of 401k Plans

401k plans are employer-sponsored retirements plans into which employees can defer some of their employment income until retirement. They do not pay tax on that portion of their income until they withdraw it in retirement, providing a tax-deferral on that portion of their income. 401k contributions are not separately reported on an employee's W-2 form as the wages reported is net of the contributions. 401k contributions reduce an employee's taxable income in the year the contributions are made.

The Earned Income Credit

This credit is based on several criteria. The taxpayer must have earned income, such as employment or self-employment income, rather than just passive income, such as income from investments. To be eligible for the EIC, the taxpayer's adjusted gross income must be below a certain level. This level changes with the number of eligible children the taxpayer has and also can change from year to year. It is refundable, meaning that, even if the taxpayer had no taxes owing for the year, she will still get the credit refunded to her.

How 401k Contributions Affect the EIC

One of the criteria for eligibility for the EIC is adjusted gross income below a certain level. Adjusted gross income includes taxable wages, self-employment net profits, investment and rental income minus certain specific deductions. These include some employment, artistic and educational expenses. 401k contributions lower the adjusted gross income because they are netted out of gross wages to arrive at taxable wages. Therefore, the higher the contributions are, the lower adjusted gross income is. This can have the effect of bringing income down enough to qualify for or increase the EIC.

Employer Contributions to 401k Plans

Employers are allowed by the IRS to contribute to their employees' 401k plans up to a certain limit that can change from year to year. These contributions are not taxable to the employee and are, therefore, "free money". Because they have no impact on an employee's taxable income, they also have no impact on the EIC.

                   

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About the Author

Angie Mohr is a syndicated finance columnist and freelancer who has been writing professionally since 1987. She is the author of the best-selling Numbers 101 for Small Business books and "Money$marts: Teaching Your Kids the Value of a Buck." She is a chartered accountant and certified management accountant with a Bachelor of Arts in economics from Wilfrid Laurier University.


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