What is Adjusted Gross Income (AGI)?
If you’ve read a bit about personal finance, chances are you’ve heard the term “adjusted gross income.” A lot of tax considerations are based on AGI, so it’s worth familiarizing yourself with the term. Here’s a quick introduction to AGI and when you might need to consider yours.
In the United States, a taxpayer’s adjusted gross income (AGI) represents that individual’s taxable earnings less allowable deductions. It represents the income tax payable for that taxpayer, and taxes are assessed based on this number, after standardized deductions. Certain benefits such as eligibility for social services are also determined on the basis of adjusted gross income. Tax forms provided by the Internal Revenue Service (IRS) are used to calculate this amount, and many US taxpayers are familiar with the process.
When a taxpayer completes an income tax form, it lists all sources of taxable income for the year. These sources of income include employment, proceeds from the sale of stocks, and capital gains from the sale of real estate, among others. Added together, they add up to the “gross income” of the taxpayer. Once the taxpayer has listed all their sources of income for the year, the AGI is calculated. Certain business expenses, payments into retirement accounts, moving expenses, child support, interest paid on student loans, and child support can all be deducted directly from gross income to produce adjusted gross income.
Then the taxpayer is allowed to take certain standardized deductions. They can choose to itemize deductions or take a “lump sum deduction,” a set amount of money based on the age and status of the filer. Once this process is complete, the taxpayer is left with a number that indicates their total income tax. Using a tax schedule, the taxpayer determines the amount of tax he owes.
Since a taxpayer’s adjusted gross income reduces total tax liability, many taxpayers try to take as many deductions as possible. They can also itemize deductions after the AGI is calculated, with the aim of reducing the total amount of tax they owe. The IRS is well aware of both of these tactics, so they review tax forms very carefully. Taxpayers should keep this in mind when making deductions, and they should take care to keep receipts and other documents handy for any deductions they plan to claim.
Adjusted gross income is also important because it is used by many organizations to make decisions such as approving a mortgage application, offering a line of credit, or allowing a taxpayer to receive government assistance. Since the sum is the basis of decisions for many basic benefits, taxpayers generally keep a copy of their taxes handy, so they have them easily accessible.
Calculation of adjusted gross income
The IRS defines AGI as “gross income fewer adjustments to income”. That’s not exactly a useful definition. It does not tell you what gross income is or what adjustments should be subtracted.
Your gross income is simply the total amount you receive in a given year. It is not limited to wages or salaries. It includes wages, salaries, bonuses, dividends, royalties, interest, business income, pensions and annuities, capital gains, and alimony that you have received.
As for tweaks, here is a brief list and description of common tweaks considered in your AGI:
- Certain expenses incurred by performers
- Certain expenses paid by teachers for books, supplies, and other equipment
- Certain travel expenses paid by members of the reserve components of the armed forces
- Losses from the sale or exchange of goods
- Certain costs associated with rental income or royalties
- Qualified retirement savings
- Pension
- Jury duty paid to your employer
- Deductions for clean-fuel vehicles
- Moving expenses
- Student loan interest
- Graduate fees
- Health savings account
Why AGI Matters
Why is your AGI important? Well, the IRS uses your AGI to determine whether or not you qualify for certain deductions and credits. For example, the IRS allows you to deduct medical expenses greater than 7.5% of your adjusted gross income. In another example, earned income tax credit eligibility is the income limit that applies to you, and all are based on adjusted gross income.
There’s yet another term you might hear used for a few other tax calculations: Modified Adjusted Gross Income (MAGI). MAGI refers to your AGI with modifications. These modifications can vary and the problem is that there is no single MAGI. And each comes with its modifications. Some common modifications include tax-exempt interest and the excluded portion of social security payments.
You should be aware of what you expect from your AGI at the end of the year, especially if you receive income throughout the year on which you do not initially pay taxes. By knowing what you are going to do, AGI will help you plan for the next tax bill. If your tax situation is simple, this probably won’t require much attention. If you and your spouse are both salaried, your AGI will be roughly the sum of your salary minus retirement savings.
If, on the other hand, you work at a paid job, pay child support, run a part-time small business, and own rental property, it’s a good idea to think about what your AGI should be. This will help you know your marginal tax bracket and plan your tax expenditures. The last thing you want is an unexpected tax bill that you can’t pay.