Cashing out your IRA completely, or just withdrawing some of it, may affect your modified adjusted gross income. Many IRA withdrawals are taxable income, and the more taxable income you have, the bigger your MAGI grows. A large MAGI affects your total tax bill by limiting your ability to clam various write-offs.
You calculate your adjusted gross income on the front of your 1040. Adjusting your gross income requires deducting various expenses, such as deductible traditional IRA contributions and student loan interest you paid. To modify your AGI, you add a lot of those deductions back in. Your MAGI doesn't include the write-offs for IRA contributions, student loan interest, excluded foreign income or any foreign-housing deductions. You still use your AGI when figuring how much taxable income you have.
MAGI's effect on your tax bill is indirect, by eliminating tax breaks. For instance, as your MAGI goes up, your ability to write off student loan interest goes down. If you're single, have no kids and your MAGI is over $14,340, as of 2013, you can't claim the Earned Income Tax Credit. A high MAGI also reduces your ability to contribute to a Roth IRA. Above a certain level -- $188,000 for married couples filing jointly in 2013 -- you can't contribute to a Roth at all.
Traditional and Roth IRAs
Almost everything you withdraw from a traditional IRA affects your income, so it affects your MAGI. The exception is after-tax IRA contributions. If 40 percent of your account is after-tax contributions, 40 percent of your withdrawal is tax-free and won't affect the MAGI. With a Roth, withdrawals of your original contributions are never taxable income, so taking them back out doesn't affect your MAGI. If you're older than 59 1/2 and you've had the account more than five years, nothing you withdraw from a Roth is taxable.
If you cash out your traditional IRA in order to convert it to a Roth, there's no problem. Although conversions count as taxable income, you get to exclude them when you're figuring your MAGI. Another option to think about is that tax-deductible contributions to your 401(k) don't get added back to your income when you figure your MAGI. If you're right on the MAGI cut-off point for various benefits, putting more income in your 401(k) may bring your income back down.
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