The Significance of Adjusted Gross Income
Understanding how adjusted gross income can impact tax efficiency is a useful skill for building wealth. Adjusted gross income impacts several possible tax credits and deductions you may be counting on each year.
I’m just sitting here watching my son’s swim practice, thinking about adjusted gross income and its little sister, modified adjusted gross income.
Naturally, the urge to write about it landed on my shoulders like a ton of bricks.
I know what you’re thinking. Totally normal.
It’s nice to be understood.
It’s also nice to understand adjusted gross income and how it impacts the amount you pay in federal income taxes each year.
Why is that you ask? We’ll get to that in a bit, but let’s start by defining what adjusted gross income is.
According to the IRS, adjusted gross income (AGI) is your gross income minus applicable adjustments to income.
Before you roll out of your seat in astonishment, allow me to elaborate.
Adjusted gross income is all of the income you make in a given year (your gross income) minus certain deductions such as:
- Expenses incurred as a teacher
- Early withdrawal penalties
- HSA deductions
- Student loan interest
- Certain capital losses
- Certain self-employment retirement savings
- Alimony payments
- Qualified contributions to certain retirement accounts
Please note that these deductions do not include those that might be taken as a part of an itemized tax return and listed on Schedule A.
For quick reference, your adjusted gross income can be found on line 11 of your 1040 on your tax return (at least that’s where it is in 2023).
So, Why is Adjusted Gross Income Important to Understand?
To begin, adjusted gross income is important because it’s a key step toward figuring out your overall tax liability for a given year.
You will either make your deductions from taxable income or take the standard deduction after you have calculated your AGI.
Beyond that, adjusted gross income is used to determine one’s eligibility for certain tax benefits or participation in certain retirement plans.
Here are a few of the things that use AGI to determine eligibility:
- The earned-income tax credit (EIC);
- The child and dependent care credit;
- Mortgage insurance premiums (MIPs) tax deduction;
- Medical expense deduction thresholds;
- Tuition payment deductions
Naturally, if you’re counting on these deductions or credits, you’ll want to know what your AGI is in order to receive them.
Perhaps most importantly though, you’ll need to know your adjusted gross income to calculate your modified adjusted gross income (MAGI).
We’ll address the importance of MAGI in further detail below.
How do I calculate my AGI?
To calculate your adjusted gross income you’ll first need to add up your taxable sources of income such as:
- Income from your job
- Self-employment income
- Income from capital gains or dividends
- Business or farm income
- Jury duty pay
- Taxable state income tax credits, refunds, or offsets
- Severance pay
- Spousal support
- Rental property income
- Unemployment income
- Payment from lawsuits
- Award money from gambling or lottery winnings
Next, you’ll subtract any applicable deductions. We posted a list above, but here it is again:
- Expenses incurred as a teacher
- Early withdrawal penalties
- HSA/FSA deductions
- Student loan interest
- Certain capital losses
- Certain self-employment retirement savings
- Alimony payments
- Qualified contributions to certain retirement accounts
The remainder is your adjustable gross income.
What is Modified Adjusted Gross Income (MAGI)
Modified adjusted gross income is AGI with several of the deductions added back in.
MAGI is important to know because it determines your eligibility for certain tax benefits like:
- Roth IRA Contributions
- Deductible Traditional IRA Contributions
- Medical premium tax credits for medical insurance purchased through a state or federal exchange
- Medicare premiums
- State Medicaid programs
So, if you regularly contribute to a Roth IRA, you should check your income each year to ensure you don’t make too much income to qualify for contributions.
Roth IRA Impact
In 2023, these are the modified adjusted gross income limits for contributing to a Roth IRA:
Filing Status | MAGI | Contribution Limit |
Married Filing Jointly | < $218,000 | $6,500 if under 50; $7,500 if 50 or older |
Between $218k and $228k | A reduced amount | |
> $228,000 | Nothing | |
Single or Head of Household | < $138,000 | $6,500 if under 50; $7,500 if 50 or older |
Between $138k and $153k | A reduced amount | |
> $153,000 | Nothing |
If you contribute more to a Roth IRA than you are allowed in a given year, you will owe a 6% penalty on the overage until you remove it.
I have over-contributed to a Roth IRA after receiving an increase in income in the middle of a year. It’s a bit of a headache to pull it back out, but it isn’t the end of the world.
Just call your IRA custodian and ask them to recharacterize the contribution. You may have options on where to move it.
In my case, we moved it into a taxable brokerage account we already had set up with the same investment company.
You will owe income tax on any gains your contributions realize before being recharacterized or paid back to you, but if you catch it within the year this shouldn’t be that much money.
Traditional IRA Impact
In 2023, here are the modified adjusted gross income limits for taking deductions on contributions to a Traditional IRA:
Filing Status | MAGI | Deductible Amount |
Single, Married Filing Jointly or Head of Household NOT Covered by Work Retirement Plan | Any Amount | Up to Max Contribution Limit |
Single or Head of Household Covered by Work Retirement Plan | < $73,000 | Up to Max Contribution Limit |
Between $73k and $83k | A reduced amount | |
> $83,000 | No Deduction | |
Married Filing Jointly Covered by Work Retirement Plan | < $116,000 | Up to Max Contribution Limit |
Between $116k and $136k | A reduced amount | |
> $136,000 | No Deduction | |
Married Filing Jointly NOT Covered by Work Retirement Plan, but spouse is | < $218,000 | Up to Max Contribution Limit |
Between $218k and $228k | A reduced amount | |
> $228,000 | No Deduction |
Unlike Roth IRAs, there are no penalties for over-contributions to Traditional IRAs, you just can’t take any deductions for your contributions if your MAGI exceeds the limits in the table above.
The absence of a tax deduction does reduce the potency of a Traditional IRA quite a bit, but it doesn’t mean you should rule out contributing to a Traditional IRA altogether simply because your income is too high.
Even the earnings of after-tax contributions will grow tax-deferred in a Traditional IRA.
You can also make after-tax contributions and convert them to a Roth IRA. This is known as a Backdoor Roth IRA and it allows individuals with high incomes to still make Roth IRA contributions.
Medical Insurance/Medicare Impact
If you retire before you become eligible for Medicare coverage at age 65, you may have to purchase medical insurance through a state or federally-operated exchange.
If you have a low enough MAGI, you may qualify for certain tax credits to help you pay for coverage.
For many people who embrace the FIRE Movement, watching modified adjusted gross income is a critical component of their monetary strategy.
Even after age 65, your MAGI will directly impact how much you pay for Medicare coverage. This could make a difference of several thousand dollars annually depending on your MAGI.
Here is a table of Medicare premiums for 2023. Bear in mind, Medicare premiums are based on MAGI from two years prior.
Filing Status | MAGI for 2021 | |||||
Single Filer | < $97k | between $97k and $123k | between $123k and $153k | between $153k and $183k | between $183k and $500k | Over $500,000 |
Married Filing Jointly | < $194k | between $194k and $246k | between $246k and $306k | between $306k and $366k | between $366k and $750k | Over $750,000 |
2023 Monthly Medicare Premium | $164.90 | $230.80 | $329.70 | $428.60 | $527.50 | $560.50 |
How Do I Calculate Modified Adjusted Gross Income?
Modified adjusted gross income is calculated by taking your adjusted gross income and adding back certain deductions like:
- Traditional IRA contributions
- Tuition
- Certain business losses
- Losses from a rental property
- Adoption expense exclusions
- Student loan interest
- Any income excluded because it was earned overseas
- Interest from EE-Bonds used to pay for higher education
Modified adjusted gross income is not calculated and listed directly on your 1040, so you may have to revisit your tax documents to figure it out.
It is possible for your AGI and MAGI to be the same.
How Can I Use This Information?
As I mentioned earlier, a few years ago we were trending toward having too much income to be able to contribute to a Roth IRA.
I discovered this AFTER we had made significant contributions earlier in the year.
By forecasting our adjusted gross income and modified adjusted gross income I was able to understand what adjustments would need to be made to our end-of-year saving and investing in order to be eligible to keep the contributions in the Roth IRA.
In the end, it was easier to pull the contributions back out of the Roth IRA for us, but if you have a similar situation, knowing your AGI and MAGI could be very valuable.
Having the right AGI or MAGI can also make a huge difference in the amount you owe on taxes each year.
With that in mind, here are some ways to reduce your adjusted gross income and modified adjusted gross income.
How Can I Reduce My Adjusted Gross Income
Here’s a list of popular ways to reduce your AGI:
- Contribute to a health savings account (HSA) or Flexible Spending Account (FSA)
- Contribute more to a Traditional IRA
- Contribute more to a Traditional 401(k), 457, 403, or Thrift Savings Plan
- Defer income or business revenue to another tax year if possible
- Tax loss harvesting
You also reduce AGI by taking deductions for student loan interest and self-employment taxes, but these are very flexible levers you can push and pull to control your AGI.
How Can I Reduce My Modified Adjusted Gross Income
For the most part, the things that will reduce your AGI will also reduce your MAGI, the only exception being investment losses. Here’s a list:
- Contribute to a health savings account (HSA) or Flexible Spending Account (FSA)
- Contribute more to a Traditional IRA
- Contribute more to a Traditional 401(k), 457, 403, or Thrift Savings Plan
- Defer income or business revenue to another tax year if possible
Conclusion
We’ve given you every ingredient you need to calculate adjusted gross income and modified adjusted gross income.
We’ve also explained why it matters and how knowing your AGI and MAGI provides an opportunity for strategic planning with your finances.
However, you won’t actually be able to calculate your AGI or MAGI with 100% certainty until the tax year has come to a close.
This makes strategic planning a bit more challenging.
At the very least, knowing how to calculate these important tax indicators will provide an enhanced opportunity to alter financial behavior for the sake of producing optimal outcomes.
