Plenty of taxpayers are left scratching their heads when Uncle Sam takes more of their income than they expected. For example, why can’t a young worker fully deduct a contribution to her traditional IRA when she seems to qualify for it? Why does a retiree owe tax on Social Security payments when his reported income is below the tax thresholds? And why are some retirees smarting from Medicare premium surcharges they thought they sidestepped?
The answer, in these cases and many others, stems from a little-understood feature of the tax code called modified adjusted gross income, or MAGI.
Taxpayers are often unaware of the ways MAGI alters the definition of income for certain provisions and how that can bring higher tax bills. Although the term doesn’t appear on the 1040 form, MAGI affects at least a dozen tax breaks used by millions of filers.
“This is an area of confusion, and some people aren’t getting benefits they thought they were,” says Eric Bronnenkant, head of tax at financial advisory firm Betterment.
Starting point
To understand MAGI, start with adjusted gross income (AGI) on Line 11 of the 1040 form. AGI includes income such as wages, self-employment earnings, interest, dividends, capital gains, many retirement-plan withdrawals and other items but not 401(k) or HSA contributions. It comes before most key deductions or tax credits, which are further down the form.
AGI is a cornerstone number: The Internal Revenue Service looks to AGI when it compiles income data, and Congress ties the thresholds for many tax breaks to it. The rub is that lawmakers have decided to limit the benefits of some provisions by modifying the AGI for them—hence MAGI.
To figure the MAGI for a particular provision, the filer usually must add back income from tax breaks elsewhere on the return to determine eligibility for the one in question. This process may be invisible if a filer is using tax-prep software or a tax preparer. Intrepid taxpayers doing their own returns will grapple with it on various schedules and IRS worksheets. Either way, it often affects outcomes.
Take the young worker who wants a full tax deduction for her traditional IRA contribution of $6,500 for 2023. She may assume she qualifies: There’s an income limit of $73,000 for her IRA deduction because she has access to a retirement plan at work, and her income will be $72,000 after a reduction of $2,500 for student-loan interest.
But the MAGI adjustment for the IRA deduction requires adding the student-loan interest back to her AGI. That raises her MAGI to $74,500 for IRA purposes. Due to a phaseout, nearly $1,000 of her contribution will be nondeductible because she’s over the limit.
Social insecurity
Other taxpayers run up against one of the oldest instances of MAGI, for Social Security benefits. When lawmakers first taxed a portion of these payments in 1984, they required recipients to add back their tax-free municipal-bond income. The aim was to prevent end-runs around the tax by filers with loads of muni-bond income.
So if a single retiree’s income excluding muni-bond interest is below $25,000, Social Security payments aren’t taxable. But if MAGI, which would include the interest, is above that threshold, up to 85% of Social Security income may be taxable.
Similarly, muni-bond income is added back when determining taxpayers’ MAGI for income-based Medicare surcharges known as Irmaa. With these surcharges, a small amount of MAGI can make a big difference because even a dollar of extra income can mean a much higher Medicare premium.
The complications don’t stop there. MAGI add-backs often differ from provision to provision.
For example, student-loan interest deductions have to be added back into income and can limit deductions for traditional IRAs and raise taxes on Social Security benefits, but they don’t affect eligibility for the child tax credit or the American Opportunity Credit for college costs.
Some common MAGI add-backs make little difference to most filers. These include tax breaks for foreign housing and foreign earned income, both abroad and in U.S. territories like Puerto Rico and American Samoa.
A few MAGI adjustments even bring benefits. The one for direct contributions to a Roth IRA excludes the amount of a filer’s Roth conversions for the year, so more savers are eligible to make these contributions. And the MAGI used for the 3.8% net investment income surtax (NIIT) doesn’t have an add-back for muni-bond interest. This will come as a relief to many investors.
Coping mechanisms
Given these complexities, how can taxpayers cope?
The first thing is to be aware of MAGI. A good place to learn details of particular MAGIs is IRS publications, such as Pub. 590-A for IRA contributions and Pub. 970 for education benefits. Sometimes the details are in the instructions to the tax form, as in Form 8960 for the NIIT, or on a government website, as for Irmaa and the ACA Premium Tax Credit.
Often the best way to sidestep MAGI issues is to lower the reported income making up AGI, says Betterment’s Bronnenkant. For employees, one way is to raise contributions to traditional 401(k)s and similar accounts, HSA accounts, and flexible-spending accounts for dependent-care or healthcare costs. Dollars going into these accounts are excluded from AGI and aren’t add-backs for MAGI.
For business owners, he recommends similar strategies where possible. These filers often have access to tax-deductible SEP IRAs and Solo 401(k)s, which don’t come with the MAGI complications of traditional IRAs. Or perhaps an owner can time the receipt of income or expenses to lower reported income, although this flexibility has limits.
Retirees also have options. They can vary taxable payouts from traditional IRAs, at least with amounts above required minimum distributions, or RMDs. And if an IRA owner is charitable, making qualified charitable distributions will help reduce MAGI. Investors with taxable accounts often have flexibility over the sale of investments with capital gains.
Of course it’s also important not to let the tax tail wag the dog, as the saying goes. But smart taxpayers will try not to get bitten by MAGI either.