Do 401(k) Contributions Reduce Earned Income Credit?

The Earned Income Credit benefits low- and middle-income working families.

The Earned Income Credit benefits low- and middle-income working families.

The Earned Income Credit allows working families a break on their federal taxes, as long as they meet the income limits. The EIC is also a refundable credit, meaning you can take it as a refund directly from the IRS even if you don't owe any taxes. If you benefit from a 401(k) retirement plan at work, your contributions may affect the amount of the EIC you may claim.

EIC Income Limits

Eligibility for the Earned Income Credit depends on the amount of your adjusted gross income, and the size of your family. With more children, the level of AGI you can have and remain eligible for the EIC rises. For tax year 2012, for example, a married couple filing jointly with one qualifying child return could claim the EIC with $42,130 or less of AGI. The maximum credit for such a family was $3,169.

The Basic 401(k)

If your employer offers a 401(k) retirement savings plan, your contributions to that plan are made with "pretax" income, meaning they are not counted in your gross income for tax purposes. Likewise, the employer's contributions are tax-free and are not reported to the IRS on your Form W-2. In effect, employer contributions to a 401(k) plan are tax-free donations to your retirement piggy bank.

Contributions and the EIC

If you earn too much to be eligible for the EIC, consider contributing more to your 401(k). Your employer will deduct the contribution from your salary, reducing your take-home pay but boosting your retirement account. This also means a reduction in adjustable gross income that you must report to the IRS. Lower AGI means a better chance of qualifying for the EIC. The more salary you can divert to the 401(k), the higher the EIC amount if you do qualify.

Distributions

A distribution from a 401(k) does not count toward the "earned income" that you must have in order to qualify for the EIC. However, 401(k) distributions do figure into your adjusted gross income. Therefore, withdrawing money from a 401(k) will push your AGI toward the level above which you won't qualify for the EIC. That's just one of the many reasons that if you're still working you should be putting money into the 401(k), not taking it out. When you do reach retirement age, you'll pay a lower rate of income tax on the distributions, assuming you're no longer working or earning less from the work you do.

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