Modified adjusted gross income (MAGI) can qualify you for a number of credits, benefits and exclusions, which makes it important to calculate for tax purposes.
In 2013, the calculation will be extremely important for students who are pursuing the federal lifetime learning credit, but in addition MAGI determines your qualification for the adoption credit, retirement savings contribution credit and education savings bond exclusion.
So why does the IRS use MAGI instead of adjusted gross income (AGI)?
AGI represents your taxable income. It is probably the most important figure for your tax return, but it may not accurately represent your total earnings. Certain sources of income are untaxable, such as foreign investment income.
These untaxable sources are added back into your AGI to calculate your MAGI. So your MAGI is a better description of your ability to pay for education, adoption or any of the other credits the federal government may give you.
Calculating Your MAGI
The IRS posts a deceptively simple MAGI calculator on its site, which helps taxpayers and tax professionals deduce the MAGI. However, closer inspection reveals a host of terms that sound intuitive but are extremely complex. After a closer look on the page, you might wonder: What is passive income? And why am I adding deductions back into my AGI? The major sticking points are explained below.
Any passive loss or passive income
This is determined on Form 1040 Schedule E and is defined as any income or loss that occurred without active engagement. Limited partnerships are one example, in which an individual might not actively manage a firm but still own a percentage. Ownership would transfer passive income or losses onto your AGI but not MAGI.
Passive losses could include any losses from rental property. If you own a rental property that has operating costs greater than the revenue it generates, you would record a passive loss. (Qualified real estate agents do not consider these passive losses because real estate activity counts as their active income.)
Passive losses cannot be deducted from active income, which can be a thorn in the side of many small business owners. However, if your MAGI is less than $100,000, you are allowed to deduct up to $25,000 in real estate losses each year. To qualify for the deduction, the IRS requires that you participate in the rental activity by contributing to impactful management decisions.
Taxable Social Security
Most Americans will not be taxed on their Social Security benefits, but some of your social security could be taxable. The amount that is taxable depends on your MAGI. For purposes of calculating your MAGI, simply take 50 percent of your Social Security benefits.
Deductions not applicable to MAGI
A number of items that you subtract from your AGI cannot be subtracted in the calculation of your MAGI. These include:
- One-half of self-employment tax. Self-employed individuals are required to pay ‘payroll’ taxes an employer would otherwise take. So they can also deduct these extra taxes to calculate their AGI. This deduction is removed for your MAGI.
- Exclusion under 137 for adoption expenses
- Student loan interest
- Income from US savings bonds (to pay higher education tuition and fees)
- Qualified tuition expenses (tax years 2002 and later)
- Tuition and fees deduction
This means that if you added any of the above to your AGI, then subtract it to calculate your MAGI, and if you subtracted it from your AGI (as in the case of passive losses) then add it to determine your MAGI.