Tax Free Income Trap, Dealing With MAGI

It was the first time that Ron’s tax return had a balance due, and he kind of freaked out. On the recommendation of the advisor at his bank, Ron purchased municipal bonds because they were tax exempt. He was shocked to learn that his Social Security benefit became partially taxable. I explained that tax free muni interest was added in with other sources of income to determine if any Social Security income would become taxable. He immediately called his bank person, who assured him that the muni interest would not cost him any tax dollars. I had to explain the concept of Modified Adjusted Gross Income, or MAGI to her.

One way to understand MAGI, is to think of your Adjusted Gross Income, or AGI, as the bottom line, and to consider MAGI as the ‘fine print’. And you should always read the fine print. MAGI is your AGI plus a few things like tax-exempt municipal bond interest and excluded foreign income. It affects a basket-full of credits and deductions, and can bring some unpleasant surprises come tax time.

So what moving parts of your tax return can MAGI gum up?

1. The deductibility of a Traditional IRA contribution
2.  Your ability to contribute to your Roth IRA
3. The Child Tax Credit
4. The Premium Tax Credit for health insurance
5. Your premiums for Medicare, IRMAA
6. The Net Investment Income tax
7. The Additional Senior Tax Deduction
8. The State and Local Tax Cap Expansion

What are you gonna do about it?

What I’m really talking about here is avoiding the MAGI surprise.

1. Worker bees can use defined contribution plans and traditional IRAs to lower income. Of course, these things only defer the tax man’s bite.
2. Here’s a great advantage of the Roth 401(k). If you know that IRRMA will be an issue in retirement, contributions to a Roth 401(k) will soothe the sting of paying tax now. Eventual Roth distributions do not affect MAGI.
3. Fixed annuities are another tool for deferring income. Sadly, they share the same disadvantage as in item #1.
4. If you are at least 70.5, using Qualified Charitable Distributions avoids the MAGI worksheet.
5. Tax Loss Harvesting. No one likes to lose money, still, this method wipes out capital gains and up to $3000 of ordinary income per year from the IRS’s prying eyes. Remember, even if your income puts you in the 0% long term capital gain rate, they still contribute to both MAGI and state income tax (if your state has a tax).
6. Taking full advantage of your Health Savings Account. Is there another method to deduct contributions, invest as you wish, and then withdraw the money tax free, and also avoid MAGI? These are a powerful tool for those eligible to have one.
7. A Home Equity Line of Credit may help. If you have a big one time expense looming, and you are close to the IRMAA cliff, you can use your HELOC instead of taking a huge distribution from your IRA.
8. Using Exchange Traded Funds, rather than managed funds in your brokerage account can cut down on those pesky capital gain distributions. Also, keeping those big dividend payers inside your IRA will help as well.
9. If your income spiked due to retirement, divorce, or the death of a spouse, you can file form SSA-44, claiming a ‘life changing event’. This won’t lower your income, but can result in a one time reset of the ‘cliff’.