You find your Adjusted Gross Income (AGI) directly on IRS Form 1040. It is relatively simple to calculate, and is critically important for a number of tax planning decisions.
You may also have to calculate your Modified Adjusted Gross Income (MAGI) to determine certain tax deductions and credits. It’s important to understand what MAGI is, and how to calculate it as well.
I’ve been looking into health insurance options for the coming year. Insurance subsidies are based on MAGI. I reviewed AGI and how it impacts MAGI. I realized there were some things I had forgotten. Several others I never knew.
So I decided that before diving into the more complex tax planning topics it made sense to first go back to basics. Understanding AGI and MAGI is crucial to limit the amount of tax you pay and optimize benefits you may qualify for.
How to Calculate Your AGI
AGI is simply your gross income minus any adjustments or deductions to your income. Generally, the higher your AGI, the higher your tax rate, and the more tax you will pay.
Calculate your AGI by:
- Adding up all of your taxable income.
- Adding up all of your total adjustments (above the line deductions) to income.
- Subtracting the sum of your deductions from the sum of your income.
Does AGI Include the Standard Deduction?
The standard deduction is not factored into your AGI. You find AGI on line 11 of IRS Form 1040. Line 12 instructs you to enter the standard deduction (or itemized deductions if it is appropriate for your situation).
From your AGI, you then subtract your standard or itemized deductions, along with any qualified business deductions from your total income. The resulting number is your taxable income.
The adjustments to your income that impact your AGI, which in turn may impact your MAGI, are often called “above the line” deductions. This is in contrast with items that you deduct from your AGI. These are frequently referred to as “below the line” deductions.
AGI, and subsequently MAGI, impact how much tax you pay in a given year and determine whether and how much in other deductions and subsidies you may qualify for. One example, which sent me down this rabbit hole, is how much ACA health insurance subsidy we will qualify for. That premium tax credit in turn determines how much we actually will pay for health insurance premiums when purchasing a plan through the Healthcare Marketplace.
Since this is so important, it is worth exploring exactly what counts as income and what above the line deductions determine your AGI. This enables you to utilize this knowledge to limit your tax burden and optimize other deductions and credits.
What is Included in Total Income for AGI?
You include almost all taxable income in your AGI. Find the inputs on Form 1040. A full list of additional income sources is found on Part I of Schedule 1 (Form 1040).
Items included as income include:
- Wages, salaries, and tips
- Taxable interest and dividends
- Taxable amount of IRA distributions, pensions, annuities, and Social Security benefits
- Capital gains (or subtract losses)
- Other Schedule 1 income (Alimony received, business income or loss, rental income, royalties, unemployment compensation, etc.)
What Items are Above the Line Deductions that Impact AGI?
Find above the line deductions that lower your AGI in Part II of Schedule 1 (Form 1040). Adjustments include:
- Health savings account deduction
- One half of self-employment tax
- Self-employed SEP, SIMPLE, and qualified plans
- Self-employed health insurance deduction
- Alimony paid (pre-2019 divorces)
- IRA deduction
- Student loan interest
- And educator expenses.
Notably absent from the list, which I find confusing, are contributions to employer sponsored retirement plans (401(k), 403(b), etc.) Contributing to these accounts lowers taxable wages on your W2. You enter these wages on line 1 of the 1040. Thus, contributing to work sponsored retirement accounts does lower your AGI, but it is not found on Form 1040 itself.
What are the Planning Implications of Understanding AGI?
Understand what items increase your AGI and what items can be deducted to lower your AGI. Then, use that knowledge to control how much you are taxed in any given year.
Tax planning becomes a balancing act. You focus on optimizing your taxes each year, with an eye on the bigger picture to ultimately limit your total tax burden over your lifetime.
Controlling Income to Optimize AGI
It is worth noting that it is virtually never smart to earn less income solely in order to pay less taxes. That is having the tail wag the dog.
The one exception is if earning a small amount of extra income pushes you over a threshold such that your marginal tax rate on that money is greater than 100%. That would result in you having less money than you started with if you never earned it.
A stark example I’ve written about in the past is getting pushed over the ACA “subsidy cliff.” (Note this rule is not in effect in 2021 and 2022). In such a case, earning one additional dollar could cost you thousands of dollars in lost ACA premium subsidies.
While you generally don’t want to earn less in order to pay less taxes, you do want to pay as little tax as possible on the dollars you do earn. Understanding how your income is taxed can help you develop a plan to minimize your tax burden.
You have more impact over decreasing your income than you do increasing your adjustments to income. However, these actions tend to take more proactive planning. You are taxed on income the year you earn it. So these actions need to take place prior to December 31 of the year you are planning for.
Earning More Efficiently
I’ve written about the Amazing Tax Benefits of Semi-Retirement. You can pay less in taxes over your lifetime by cutting back on work sooner, earning less annually, and spreading out your income over more years.
We have been cutting back work gradually, allowing us to incrementally improve our lifestyle sooner. In doing so, we keep about eight cents more out of every dollar earned compared to when we were both working full-time.
Timing Strategies for Investments
Another way to limit your total taxation is to utilize timing strategies. Shift income taxes to pay them in the year it is most beneficial to you, as opposed to in the year you earn the money.
Strategies to lower taxable income allow you to avoid paying taxes in higher earning years. You can defer tens of thousands of dollars per year in work sponsored retirement accounts. Harvesting capital losses is another way to lower income in high earning years.
Conversely, strategies such as performing Roth IRA conversions and tax gain harvesting may be beneficial in lower earning years of early retirement, voluntary sabbaticals, or unplanned unemployment. They are the opposite side of the tax deferral coin. These strategies accelerate the timing of paying taxes to lower earning years when it is to your advantage.
Having a high savings rate and taxable investments are prerequisites to utilize these tax deferral strategies. Early retirees who can spread income across many lower earning years would most benefit from timing strategies.
I’ve described these strategies in detail in the blog post Early Retirement Tax Planning 101.
Timing Strategies for Business Income
Business owners pay tax on their net income in a given year. Net income is simply income minus expenses. This provides another opportunity to incorporate timing strategies.
If you are near an income threshold you don’t want to cross and you can incur expenses you will eventually have anyway, you can accelerate the expenses to the current year. This would lessen your profit and thus your taxable income for the year.
Conversely, if your household is having an unusually low income year, you may want to hold off on unnecessary expenses. Further lowering your taxable income in an already low income year may not be to your advantage.
Wait and incur the expense at the beginning of the following year. This way you can lower taxable income in a year when it will potentially be more advantageous for you.
Choosing and Locating Investments Wisely
Another strategy to control taxable income is selecting tax efficient assets to hold in taxable accounts. Examples of tax efficient investments are total market ETFs, index funds, and individual growth stocks you plan to buy and hold forever. Municipal bonds and IBonds work well also.
These investments produce a relatively small amount of dividend income which is taxed favorably. They create little to no capital gains or taxable interest until you sell. Thus you can control paying taxes until you need the income.
Place less tax efficient investments such as REITs, actively managed mutual funds that trade and create capital gains, dividend focused stocks, or bonds that produce a lot of income in tax-advantaged accounts. There, the income they produce will not be subject to annual taxation.
Maximizing Above the Line Deductions to Lower AGI
Similarly, knowing what above the line deductions you use can enable you to control your AGI. I’ll briefly highlight a few common examples of how you can increase your deductions to decrease your AGI.
You tend to have less impact over increasing your adjustments to income than decreasing your income. However, some of these actions provide additional flexibility after a year ends.
This is useful if you don’t manage income well and realize after a calendar year ends that you need to lower AGI. For example, you can contribute to a deductible IRA or HSA up until the tax filing deadline, retroactive to the previous tax year.
Using HSA and IRA Accounts
You find Health Savings Accounts (HSA) and Individual Retirement Accounts (IRA) contributions on the adjustments to income on Schedule 1 (Form 1040). You can strategically use these accounts with timing strategies similar to those described above. There are some noteworthy features about these accounts.
An HSA provides a deduction that lowers AGI in the year of the contribution and provides tax free growth of investments similar to other tax-deferred accounts. HSAs are particularly attractive because they also allow tax-free future withdrawals if the money is used for qualified medical expenses.
Related: Using a HSA to Save for Retirement
An IRA functions similarly to work related retirement accounts. Key differences are that deductible IRAs are subject to income limits that work related accounts are not. IRAs also have lower contribution limits than those of work related retirement accounts.
Deductions for Business Owners
Business owners have several opportunities to lower AGI that employees do not. Like lowering income to avoid paying taxes, starting a business solely for the tax benefit is almost always a bad idea. But if you are on the fence about entrepreneurship, understanding tax deductions may incentivize starting a business.
You deduct health insurance costs if you are self-employed. For an early retiree who is considering some part-time or consulting work, this may be an incentive to establish yourself as a self-employed consultant or private contractor as opposed to being paid as a W2 employee.
Another advantage of entrepreneurship is the ability to set up a self-employed retirement account. These function similarly to employer sponsored retirement accounts, but they enable you to defer substantially more money.
What is Modified AGI and How Do You Calculate It?
AGI is simple to find on your tax form and fairly straight forward to calculate. MAGI is not.
You will not find MAGI anywhere on your tax return. In fact, there is no uniform definition of MAGI or way of calculating it.
Instead, you modify your AGI in different ways for different deductions and credits. A couple of common examples when MAGI is used are of particular interest to readers of this blog is determining:
- Premium Tax Credits when purchasing health insurance
- Eligibility to deduct an IRA contribution
- Eligibility to contribute to a Roth IRA.
For health insurance premium tax credits (PTC), find instructions to determine MAGI on Worksheet 1-1 and 1-2 in Form 8962.
Find instructions to calculate MAGI to determine if you are eligible to make a deductible contribution to an IRA or contribute to a Roth IRA on Worksheet 1-1 and Worksheet 2-1 respectively from IRS publication 590A.
It is instructive to look at these worksheets. The calculation to determine MAGI for IRA contributions is different than for Roth IRAs. Both are different from the MAGI calculation that impacts health insurance PTC.
Take Home Message For Understanding AGI and MAGI
AGI is straightforward to find, understand, and calculate. It comes directly from Form 1040 of your tax return.
MAGI is a term without a single definition. You calculate your Modified AGI differently under different circumstances. It is often close to, or may even be equal to, your AGI. It would be nearly impossible to memorize all the different calculations and nuances of MAGI for different provisions of the tax code.
This is why even for those of us with relatively simple tax situations and a serious interest in our personal finances, purchasing tax software or consulting with a tax professional when tax planning is likely a good investment. It could pay dividends in saved money and time.
However, it is important to not turn off your brain. This is easy to do if you blindly follow prompts on a screen or trust the “expert” who does your taxes.
Take some time to review your past returns. Recognize the ways you can impact your AGI. Consider how AGI is modified for factors relevant to your situation.
Then automate your finances as much as possible to optimize these numbers. Also, understand you may be able to take actions after the calendar year ends to get additional deductions.
These simple actions can lower your AGI and MAGI and directly impact your taxable income and benefits you are eligible to receive.
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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at email@example.com.]
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