Modified Adjusted Gross income (MAGI): A Simple Guide for Small Business Owners

One tax term that sometimes trips up my clients is Modified Adjusted Gross income, or MAGI. 

You may have seen this acronym on tax forms, health insurance applications, or when determining your eligibility for tax deductions or credits. You know I’m all about empowering small business owners to take charge of their finances, so in today’s article, I’ll break down what MAGI is, why it matters, and how it affects small business owners.

What is Modified Adjusted Gross Income (MAGI)?

To understand MAGI, you’ll need to understand the two underlying concepts of gross income and adjusted gross income (AGI):

• Gross income includes everything you earn from wages, self-employment income, rental income, dividends, capital gains, interest, etc.
• Adjusted Gross income (AGI) is calculated by subtracting certain IRS-approved adjustments from your gross income. These adjustments could be for things like contributions to a traditional IRA, student loan interest, or the self-employment tax deduction.

MAGI starts with your AGI and adds back some of the deductions that were taken out. The IRS uses MAGI for certain tax calculations, especially when determining eligibility for credits, deductions, and benefits, such as:

• Roth IRA contributions  
• Premium tax credits for purchasing health insurance through the Health Insurance Marketplace  
• Education tax credits like the American Opportunity Credit or Lifetime Learning Credit  
• Passive activity losses  
• Rental real estate deductions  

How is MAGI calculated?

The main reason MAGI is so confusing is because the IRS uses different versions of MAGI depending on what you’re applying for. Like I explained above, the general formula is:

MAGI = AGI + add backs for certain deductions or exclusions

Some common amounts you may have to add back in to calculate your MAGI include:

• Deductions for IRA contributions
• Student loan interest
• Foreign earned income exclusion
• Half of your self-employment tax
• Tuition and fees deduction
• Passive loss or passive income
• Excluded savings bond interest
• Excluded employer adoption benefits

So how does this look with numbers? Well, let’s say you’re a self-employed graphic designer. Your numbers might look like this:

• Gross income = $120,000
• Self-employment tax deduction = $8,500
• Health insurance deduction = $6,000
• Traditional IRA contribution = $5,000
• AGI = 120,000 – 8,500 – 6,000 – 5,000 = $100,500

But if you’re determining eligibility for a Roth IRA, the IRS requires you to add back your traditional IRA contribution, so your MAGI looks like this:

• MAGI = 100,500 + 5,000 = $105,500  

Why should I pay attention to MAGI?

As a small business owner, your income can sometimes vary widely from year to year. This makes understanding MAGI important because it can and should play a part in how you make financial decisions in other areas, such as:

• Retirement Contributions: Roth IRA eligibility phases out at higher MAGI levels, so if your income is too high, then you’ll need to look for other retirement plan options like an SEP IRA or a Solo 401(k) plan.  
• Health Insurance Premium Tax Credits: If you buy your health insurance through the federal Health Insurance Marketplace, your MAGI is what is used to determine how much assistance you can qualify for. A few thousand dollars in additional MAGI can significantly reduce your insurance premium subsidies or eliminate them entirely.  
• Education Credits: If you’re paying for your or your child’s college tuition, your MAGI is what determines whether you’ll qualify for education tax credits like the American Opportunity Credit or the Lifetime Learning Credit.  
• Rental Property Deductions: If you own rental properties, then your MAGI can also limit your ability to deduct passive losses from your properties (the $25,000 special allowance phases out if your MAGI is over $100,000).  

Can I reduce my MAGI?

Yes, the good news is that there are strategies you can use to reduce your MAGI, especially if you know ahead of time which tax credits, deductions, or benefits you’re seeking. Here are some general tax-saving strategies I share with my clients to help them lower their MAGI:

• You can max out your retirement contributions to reduce your AGI. Just keep in mind that some deductions, like IRA contributions, may get added back when calculating your MAGI.  
• If you can, use a Health Savings Account (HSA) to help reduce your AGI as HSA contributions aren’t usually added back when calculating MAGI.  
• If you have control over when you can recognize income or expenses, you can potentially level out any income spikes in your books. This is a way to strategically manage your MAGI for the tax year.  
• If you have capital gains and losses, you can use tax-loss harvesting to your advantage to potentially offset capital gains and reduce your MAGI.  

Since calculating MAGI varies and because many different factors go into a successful tax and financial plan, my biggest piece of advice for small business owners is to consult an accountant who is well-versed in working with entrepreneurs like you. A small shift in timing or deductions can end up saving you thousands of dollars in taxes, especially if your MAGI is near any of the phase-out thresholds that may apply to you.

Abridged by Amy

MAGI is one of those hidden numbers that can carry a lot of weight when it comes to tax planning. Knowing how your MAGI is calculated and how that applies to potential tax-saving strategies can help you make smart decisions for your business and other related areas of your life like retirement, healthcare, and education.