Mr Gates plans to spend more time working at his foundation on global health and education initiatives.
The co-founder of the world's biggest software company and the richest individual in the world will “continue to serve as the company's chairman and an advisor on key development projects,” according to a Microsoft statement.
"This is a hard decision," said Mr Gates, adding that he was not retiring but "reordering [his] priorities."
Mr Gates stressed that he was not leaving the firm but simply starting a "transition phase."
The company announced a two-year transition process "to ensure that there is a smooth and orderly transfer of Mr Gates” daily responsibilities.’
Mr Gates had already given up some responsibilities at Microsoft by handing the title of chief executive to Steve Ballmer while retaining the title of chairman and "chief software architect."
The company announced that chief technical officer Ray Ozzie "will immediately assume the title of chief software architect and begin working side by side with Gates on all technical architecture and product oversight responsibilities, to ensure a smooth transition."
Another chief technical officer, Craig Mundie, will take the new title of chief research and strategy officer.
"Our business and technical leadership has never been stronger, and Microsoft is well positioned for success in the years ahead.
“I feel very fortunate to have such great technical leaders like Ray and Craig at the company," Mr Gates said.
"I remain fully committed and full time at Microsoft through June 2008 and will be working side by side with Ray and Craig to ensure that a smooth transition occurs."
Analysts said the move had not come as a huge shock and that two years provides enough time to make the change.
"The people who are taking over are very experienced and have been with Microsoft for a while," said Jean Orr, an analyst with Nutmeg Securities.
Daryl Nanes, principal at Nanes Delorme Capital Management said: "I don't think Gates stepping away from his day-to-day responsibilities at Microsoft will be negative for the rest of the market.
"But Microsoft shareholders are assumed to have some jitters about the ambiguity regarding the future leadership of the company that Gates founded and ran for over 20 years," he added.