Are Capital Gains Included in MAGI? What You Need to Know

Understanding Modified Adjusted Gross Income (MAGI) is crucial for financial planning, as it determines eligibility for various tax benefits and credits. A common question is whether capital gains are included in MAGI, given their potential impact on tax liabilities.

Key Components That Affect MAGI

MAGI starts with Adjusted Gross Income (AGI), which is derived from gross income after specific deductions like retirement contributions and student loan interest. To calculate MAGI, certain deductions and exclusions are added back to AGI, broadening the income base. For example, non-taxable income, such as tax-exempt interest from municipal bonds, is included in MAGI to ensure individuals with significant tax-exempt income are not unfairly advantaged. Foreign earned income and housing exclusions are also added back to AGI in this calculation.

Capital gains, both short-term and long-term, are part of AGI and therefore impact MAGI. Short-term gains, taxed at ordinary income rates, can substantially increase MAGI, particularly for high earners. Long-term gains, taxed at preferential rates, still contribute to overall income. This inclusion can affect eligibility for tax credits like the Premium Tax Credit or deductions such as the Student Loan Interest Deduction, which are tied to MAGI thresholds.

Distinguishing How Capital Gains Are Classified

Capital gains are categorized as short-term or long-term, which determines how they are taxed. Short-term gains, from assets held for a year or less, are taxed at ordinary income rates, which can be as high as 37% for top earners in 2024. Long-term gains, from assets held for more than a year, are taxed at preferential rates of 0%, 15%, or 20%, depending on income. This distinction incentivizes long-term investment.

Taxpayers report capital gains on Schedule D of Form 1040 and may also need to account for the net investment income tax (NIIT), an additional 3.8% tax on high-income individuals. Proper reporting is essential for accurate tax filing and avoiding penalties.

Situations Where Gains Are Included

Capital gains influence a taxpayer’s financial obligations. When assets like stocks or real estate are sold, the resulting gains are included in taxable income and can affect calculations such as the Alternative Minimum Tax (AMT), which recalculates taxable income by adding back certain deductions and exclusions.

In estate planning, heirs benefit from a “step-up” in basis when assets are inherited, adjusting the asset’s value to its fair market value at the time of inheritance. This reduces potential capital gains taxes when the asset is eventually sold. However, this benefit does not apply to gifted assets, where the recipient assumes the original purchase price as the basis.

In retirement planning, selling appreciated assets in taxable accounts can push income into higher tax brackets, impacting strategies like Roth IRA conversions. Timing these transactions carefully can help manage the effect on MAGI and tax liabilities.

Adjustments and Exclusions That May Apply

Tax-loss harvesting allows investors to offset capital gains by selling underperforming assets. Losses can be deducted against gains, up to $3,000 annually for individuals, with any excess carried forward.

The exclusion for the sale of a primary residence enables homeowners to exclude up to $250,000 of capital gains ($500,000 for married couples filing jointly) if ownership and use tests are met. This can significantly impact taxes for those with substantial property appreciation.

Qualified small business stock (QSBS) held for more than five years may qualify for up to 100% exclusion of gains, subject to certain limits. This provision encourages investment in small businesses through tax incentives.

Potential Effects on Deductions or Credits

Including capital gains in MAGI can reduce or eliminate eligibility for deductions and credits. Many tax benefits phase out as MAGI increases, creating financial challenges for those with significant gains.

For example, the Premium Tax Credit (PTC), which offsets the cost of health insurance under the Affordable Care Act, is available to taxpayers with MAGI between 100% and 400% of the federal poverty level (FPL). Large capital gains can push MAGI above this range, disqualifying taxpayers from the credit and increasing out-of-pocket health insurance costs.

Deductions like the Student Loan Interest Deduction phase out for single filers with MAGI over $85,000 in 2024. Similarly, contributions to a Roth IRA are limited by MAGI thresholds—$153,000 for single filers and $228,000 for married couples filing jointly in 2024. Exceeding these limits due to capital gains prevents direct contributions, though a backdoor Roth IRA conversion may provide an alternative, albeit with additional complexity.

Proactive tax planning is essential to manage the interplay between capital gains and MAGI, ensuring taxpayers remain eligible for deductions and credits while minimizing liabilities.