AGI, MAGI, And You
Adjusted gross income (AGI) is an important number to understand on your tax return. Why? Your eligibility, cost, or subsidy for many programs is determined by it.
Some examples are:
- Medicare premium surcharges
- Obamacare premium subsidies
- College financial aid
- Income-based student loan payments
- Roth IRAs
- Government social programs
You get the idea. Nearly everyone — young adult or old, high income or low — can be affected so it pays to understand how AGI is calculated and the levers you have to minimize it.
How is AGI calculated?
The easiest way to understand the IRS’s logic and semantics is to just accept it; if you try to fit it into conventional norms, you’ll go mad.
Here’s a simple explanation for AGI:
- Start with your “total income” which is roughly what you earned last year, plus investment income and non-Roth retirement account distributions. If you contributed to your employer’s pre-tax 401K or dependent care or flexible savings accounts, these amounts are already subtracted from your income so they’re not included in your AGI.
- Subtract “adjustments” from this total income to arrive at your AGI. These are listed on the 1040 Schedule 1. The most common ones are contributions to health savings accounts, contributions to pre-tax IRAs, alimony, and student loan interest. These adjustments are sometimes known as “above the line” because they are subtracted before arriving at AGI.
- This is your AGI. It’s line 8b on your 2019 1040 tax return; in 2018, it was line 7.
- Note that itemized “deductions” listed in Schedule A (e.g., mortgage interest, state taxes, charitable contributions) or the standard deduction if you do not itemize do not reduce your AGI. These are sometimes known as “below the line” because they are subtracted from your taxable income after determining your AGI.
What’s the difference between an adjustment and a deduction? In IRS-speak, both equally reduce your taxes but an adjustment reduces your AGI while a deduction doesn’t.
How can you reduce your AGI?
With smart planning and some lead time, you can influence how your AGI may ebb and flow in different years. Here are some ways to reduce your AGI or shift the timing:
- Use a high deductible health plan and contribute to a health savings account. There’s no better deal than an HSA.
- Contribute to a pre-tax 401K. I’m usually in favor of the Roth version but if you’re trying to minimize your AGI, go pre-tax instead.
- Contribute to a pre-tax IRA instead of a Roth IRA. Again, I usually favor a Roth but not if you want to minimize your AGI for that particular year.
- Don’t do a Roth IRA conversion (something I often advocate for other reasons) as it will add to your AGI.
- On the other hand, distributions from pre-tax retirement accounts also increase your AGI; distributions from a Roth account do not. So, Roth conversions may be a smart move in years in which you’re not trying to minimize your AGI.
- Contribute to your dependent care and flexible spending accounts at work.
- Contribute to a 529 account for your kid(s) as the investment income won’t be counted.
- Invest in tax-free municipal bonds instead of taxable ones as the interest income is excluded from your taxable income.
- Delay claiming Social Security benefits (which is usually a good idea anyway) until a later age.
- Realize capital losses but avoid taking capital gains.
- If you pay or receive alimony, shift the timing in a way that could benefit both you and your ex-spouse.
And then there’s something called MAGI.
AGI’s close kin is modified adjusted gross income (MAGI). Only the government could modify something that’s already adjusted. Maybe it should have simply been adjusted adjusted gross income? However I digress.
MAGI, as you may infer, is a modification of AGI. Some adjustments are added back to potentially arrive at a higher amount. I lied slightly when I said all of those programs are based on AGI — many of them are pegged to MAGI (which is based on AGI). However, different programs calculate MAGI differently so there is no singular definition of it. Unlike AGI, there is no line item on your tax return for MAGI.
For example, in some MAGI flavors, IRA contributions and/or tax-exempt interest income are added back. So, those two suggestions won’t always reduce your MAGI. Just note that MAGI is derived from AGI and it’s possible that some of the ways to reduce AGI may be added back if MAGI is being used. Confusing? Of course it is.
So when you’re trying to minimize your AGI for any reason, carefully understand which measure of AGI or MAGI is being used and be smart about the timing of whatever you do.