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How Does Adjusted Gross Income Work?
One of the most common terms you’ll hear in regard to taxes is “adjusted gross income.” Despite only being three words long, the subject can be challenging to understand—especially if you don’t have much personal history in the financial industry, or experience working with taxes.
In this article, we’ll explain the basics of adjusted gross income (AGI), how to calculate it for yourself, and why it’s so important in the first place.
Adjusted Gross Income (AGI) 101
We’ll start with a basic definition of adjusted gross income (AGI). Everything starts with your gross income—the amount of money you make before taxes and other deductions. This is your on-paper salary, and the amount of money on your paycheck before withholdings and other deductions.
Your AGI is determined by taking your gross income and adjusting it to account for different deductions. Simply put, your adjusted gross income (AGI) is a measure of how much of your income is taxable. It’s usually one of the earliest calculations you’ll make for your taxes, and provides the basis for much of your tax work—including which credits and other deductions you qualify for.
The deductions used to calculate AGI from gross income are considered to be “above the line” deductions, meaning they apply before tax exemptions for military service, dependent status, and similar variables. Above the line deductions also apply before Schedule A itemized deductions, as well as standard deductions.
Your AGI will be used for your federal tax return, and in many cases, your state-level return.
Types of Deductions That Affect Your Adjusted Gross Income
What types of deductions will affect your adjusted gross income (AGI)?
These are some of the most common:
Retirement plan contributions.
Contributions to certain retirement plans may apply.
Half of your self-employment tax.
Half the self-employment taxes you’ll owe may apply to your adjusted gross income.
HSA (Healthcare Savings Account) deductions.
If you have deductions from a
, they will apply.
This is the alimony you paid; the recipient will report theirs as part of their gross income.
Moving expenses are only available in certain circumstances, since the rules for reporting changed in 2018.
Losses from property sales.
If you sold or exchanged property and took a loss, your loss will apply here.
Withdrawal penalties from certain financial institutions.
If you face early-withdrawal penalties from certain accounts or from certain organizations, they may apply.
Academic fees and student loan interest.
School tuition, academic fees, and some types of student loan interest will apply. Note that there are usually exceptions and limitations to consider here.
Jury duty pay (if handed to your employer).
If your jury duty pay was turned over to your employer, you can likely include it.
Certain business expenses.
In some industries, you may be able to include business expenses; this applies to performing artists, reservists, teachers, and some government officials.
Calculating Adjusted Gross Income
To calculate your AGI, you’ll first need to know your total gross income. This income includes all your sources of revenue in a given year, including your salary, wages, dividends, capital gains, interest, rental income, retirement distributions, alimony, and royalties. You’ll need to add all these sources up to get your total gross income.
Next, you’ll need to calculate your applicable deductions and payments, referencing the list in the previous section. Subtract these deductions and payments from your total gross income, and you’ll get your adjusted gross income (AGI).
From there, you’ll be able to apply the standard federal tax deduction or itemized deductions to reach your final taxable income.
Adjusted Gross Income (AGI) vs. Modified AGI (MAGI)
While similar in name, your adjusted gross income is not the same as your modified adjusted gross income (MAGI). Your MAGI will modify your AGI even further, factoring in variables like your foreign earned income, higher education costs, and tax-exempt student loan interest. You’ll use MAGI for calculating some types of tax benefits, credits, and exclusions.
Most taxpayers will calculate their adjusted gross income using IRS form 1040. This is the standard form provided by the IRS, which individual taxpayers can use to file their tax returns. On this form, you’ll report your gross income, and calculate the amount of taxes you’ll owe.
This form is only two pages long, and is designed to be as straightforward as possible. You’ll need to enter personal information like your name, address, and social security number, as well as your dependents.
From there, you’ll begin to make calculations, guided in a number of lines that include:
Wages, salaries, tips, etc.
This includes all money you’ve made from employers; you’ll also need to attach your W-2 form.
Tax-exempt interest and taxable interest.
Provide information on all the interest you’ve received from your accounts.
Qualified and ordinary dividends are considered.
as well as pensions and annuities.
Social security benefits,
Capital gains or losses.
You may need to attach Schedule D if you’re using this line.
On line 7, you’ll calculate your total income, and subtract an amount of money based on your above the line deductions. This will leave you with your adjusted gross income.
Standard or Itemized Deduction?
Once you have your adjusted gross income, you’ll need to decide whether you want to apply the standard deduction, or use itemized deductions. Whatever you choose, you’ll apply these deductions to lower your adjusted gross income further, eventually leading you to your total “taxable income,” which will be used for the rest of your tax return.
The “standard deduction” is a set dollar amount that will reduce your adjusted gross income. This will vary, depending on your current filing status. For example, in 2019, the individual (single or married, filing separately) deduction is $12,200. The married filing jointly deduction is $24,400. The head of household deduction is $18,350. Certain qualifications may increase your total standard deduction, like if you’re blind or if you’re age 65 or older.
Itemized deductions will reduce your adjusted gross income based on certain qualifying expenses, like paid mortgage interest, real estate taxes, charitable contributions, and unreimbursed expenses. If you have many of these expenses, adding up to more than your standard deduction, you may benefit from choosing the itemized deduction route. There are upper limits for the itemized deductions you can claim, based on your filling status.
Most taxpayers choose to take the standard deduction these days. The standard deduction is higher for most people who don’t have excessive individual expenses. It also has a few other advantages; for example, you won’t need to worry about keeping track of all your itemized expenses, meaning your tax return is going to be simpler. You’ll also forgo the need to track individual expenses; if you’re ever audited by the IRS, you won’t need to prove a long list of expenses with receipts and records.
Wrapping Up Adjusted Gross Income
The easiest way to think of your adjusted gross income is to think of it as your gross income minus initial adjustments. From there, your taxable income will be calculated as your adjusted gross income minus your exemptions and deductions for the year.
Taxes can be complicated, especially if you’re inexperienced. Fortunately, you don’t have to do this alone. While Form 1040 is only two pages, it can be confusing if you’re not familiar with the terminology cited. Get professional help with Taxfyle to make sure you calculate your adjusted gross income correctly, and get the best possible return on your taxes.
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