As an individual or couple planning for retirement, you need to be familiar with the term "Modified Adjusted Gross Income" or MAGI. It's a term that is thrown around a lot in retirement planning, but it can be hard to understand what it means without some explanation. However, it is not only important to understand what it means, but you also need to understand how it is used. MAGI is used in several different retirement related tax calculations. Everything from whether you can contribute to a Traditional IRA or Roth IRA, various tax credits and deductions, to how much your premiums may be for Medicare. But, potentially, the most important reason for retirees to understand MAGI is that it is also used to determine how much of your Social Security is going to be taxable. You may also consider projecting future MAGI to help assist in determining when to actually start receiving Social Security benefits or whether to consider other tax strategies such as Roth conversions. In this post, we will break down exactly what MAGI is, but more importantly, show how understanding it can help in planning a successful retirement!
What is your Modified Adjusted Gross Income?
Your MAGI is determined by subtracting from (or not including in) your adjusted gross income (AGI) the taxable amount of your Social Security benefit and adding back in any income that is normally excludable from your AGI, such as foreign earned income and income from qualified U.S. savings bonds.
TIP: On IRS Form 1040, your AGI is your gross income minus certain deductions allowed by law (known as "above-the-line" deductions). These include deductions for IRA contributions, the cost of self-employed health insurance, and alimony paid, among other expenses.
Example(s): When Pat calculated his MAGI, he added up his wages from his employer, dividend income from an investment, income from his pension, and income he earned overseas that year. However, he didn't include his Social Security retirement benefit in the calculation. The resulting total figure represented his MAGI.
How Does MAGI Impact Social Security?
Somewhere between 0% and 85% of your Social Security benefits will be included in your taxable income. The specific percentage for you will be determined by your other income sources. The actual income amount that is used to determine your Social Security taxation is known as Provisional Income. Provisional Income is equal to Modified Adjusted Gross Income (MAGI) plus half of your Social Security benefits.1
• For Single Filers with less than $25,000 and Married Filers with less than $32,000 in Provisional Income, 0% of Social Security Benefits will be taxable.
• For Single Filers with $25,000 to $34,000 and Married Filers with $32,000 to $44,000 in Provisional Income, up to 50% of Social Security Benefits will be taxable.
• For Single Filers above $34,000 and Married Filers above $44,000 in Provisional Income, up to 85% of Social Security Benefits will be taxable.
How Can You Reduce MAGI?
When you fill out your income tax return, you'll have to calculate your gross income (income section on IRS Form 1040 or 1040A). Your gross income encompasses many types of income, such as your wages, salary, and tips from your employer; business income; taxable interest income; unemployment compensation; the taxable portion of distributions from your IRA; pensions and annuities; and the taxable portion of your Social Security benefit. However, before you figure out how much tax you owe to the IRS, you will be allowed to adjust (reduce) your gross income. You can reduce your gross income in three ways: reduce your business income, reduce your investment income, and create "above-the-line" deductions
1. Reduce Your Business Income
You must report any business (self-employment) income you had on your income tax return. One way to reduce your MAGI is to reduce the amount of business income you must report on your tax return. You may be able to reduce the amount of business income you have in two ways: by postponing or accelerating income and by finding deductions to offset your business earnings.
- Postponing or accelerating income: If you're self-employed, your income is generally considered taxable in the year it's received rather than in the year it's actually earned. So, if you want to reduce your business earnings for a taxable year, you can postpone receiving income you earned that tax year until the next tax year. The flip side to this strategy is that if it would benefit you tax-wise, you can also try to accelerate income by receiving it before you might have otherwise.
- Finding business deductions: Most businesses don't pay income taxes on their entire business earnings. Just as tax law allows individuals to take deductions against their wages, businesses are allowed to take deductions against their earnings. Common business deductions include labor costs, travel expenses, advertising expenses, and business asset expenses. These deductions can greatly reduce business income. In fact, if a business has many deductible expenses, the business may show a loss instead of a profit. This loss can be reported on Form 1040 and subtracted from other income you may have.
Caution: Postponing or accelerating income could have other tax consequences, so discuss this strategy with a tax professional. For example, if your self-employment income for the year is high enough, you could be subject to the additional Medicare payroll tax of 0.9% that is levied on net self-employment income that exceeds a certain threshold amount for your filing status. For more information, see irs.gov.
2. Reduce current investment income
Both taxable and tax-exempt investment income are included in the MAGI calculation. Reducing the amount of income that you currently recognize from your investments will help decrease your MAGI. One way to accomplish this would be to invest in growth stocks or mutual funds that tend to appreciate rather than pay current dividends. Or, you might invest in U.S. Series EE savings bonds; for most individuals, the interest income will not be recognized until the bonds mature, you dispose of the bonds, or you redeem them.
Caution: Before investing in a mutual fund, carefully consider the investment objectives, risks, charges, and expenses of the fund. This information can be found in the prospectus, which can be obtained from the fund or from your financial professional. Read it carefully before investing.
3. Generate above-the-line deductions
Above-the-line deductions lower your AGI, and thus your MAGI. These deductions are available to all taxpayers who qualify, whether they itemize or not, and include deductions for IRA contributions, health savings account contributions, one-half of self-employment tax paid, and premiums paid for self-employed health insurance. Consult your tax advisor if you have any questions.
Benefits of Reducing MAGI
Reducing your gross income can reduce your total income tax liability
When you reduce your gross income, you'll reduce the total amount of income tax you pay, not just the tax you pay on your Social Security retirement income. The amount of tax you save will depend on your tax rate.
Reducing your gross income can help you avoid loss of Social Security benefits due to excess earnings
If you have earned income over a certain annual limit after you begin receiving retirement benefits and you are under normal retirement age, your monthly benefit will be reduced proportionately. Thus, reducing your gross income may help you keep more of your retirement benefit.
Tradeoffs of Reducing MAGI
Reducing investment income may decrease cash flow
You should think twice about converting your investments to growth stocks or mutual funds if you rely on the dividends or interest those investments pay to provide much-needed retirement income.
Just by the name, Modified Adjusted Gross Income can sound confusing. However, as discussed above, it is a significant number to get your head around to help you make intelligent retirement decisions. If you need help calculating your MAGI or understanding the impact on your retirement plan, be sure to consult your tax advisor or financial advisor for further guidance.
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