Understanding Adjusted Gross Income

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:

• Obamacare insurance premiums
• Need-based college financial aid
• Income-based student loan payments
• Medicare premium surcharges (“IRMAA”)
• IRA eligibility
• Government social programs
• Pandemic relief checks

You get the idea. Nearly everyone — young or old, high income or low — can be affected so it’s worth understanding how AGI is calculated and the dials you can turn to minimize or shift it to different years.

How is AGI calculated?

There’s no coherence in how AGI is defined. It’s easiest to just accept the IRS’s formula as you’ll go mad if you try to fit it into conventional norms of logic. (In fairness to the IRS, the Congress sets these rules and the IRS is tasked with implementing the insanity that is our tax return system.)

Here’s a simple explanation for AGI:

1. Start with your “total income” which is roughly what you earned last year, plus other income from investments and pre-tax 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.
2. 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 and 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.
3. This is your AGI. It’s line 11 on your 2020 1040 tax return.
4. 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 is more valuable because it reduces your AGI while a deduction doesn’t. Again, don’t try and make sense of the semantics.

How can you reduce or shift 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:

1. Use a high deductible health plan and contribute to a health savings account. There’s no better deal than an HSA.
2. Contribute to a pre-tax 401K or IRA. I usually favor a Roth but if you’re trying to minimize your AGI, go pre-tax instead.
3. Don’t do a Roth IRA conversion (something I often advocate for other reasons) as it will increase your AGI.
4. 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 because they will lower your AGI in future years.
5. Contribute to your dependent care and flexible spending accounts at work.
6. Contribute to a 529 account for your kid(s) as the future investment income won’t be counted in your future AGI.
7. Invest in tax-free municipal bonds instead of taxable ones as the interest income is excluded from your taxable income.
8. Delay claiming Social Security benefits until a later age (which is usually a good idea anyway).
9. Realize capital losses but avoid realizing capital gains.
10. 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 MAGI.

AGI’s close cousin is modified adjusted gross income (MAGI). Only the IRS could modify something that’s already been adjusted. 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. 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 may not 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 if 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. It can save or cost you meaningful amounts of money over the years.