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26 January 2021 / Tax Preparation

How Does Adjusted Gross Income Work?

26 January 2021 > Tax Preparation

How Does Adjusted Gross Income Work?

The term “adjusted gross income” can elicit schoolyard snickers: It’s gross! 

But in the context of tax, this term is far less amusing. Gross here means “without deduction of tax or other contributions; total.” So your gross income is the amount of money you bring in before Uncle Sam takes any of it. And your adjusted gross income (AGI) is that amount… after some adjustments. 

In this article, we’ll explain just what those adjustments are and how to make them, along with whether you’re allowed to just bury your head in the sand like an ostrich until April 15th passes. 

What Is Adjusted Gross Income?

Tax preparation begins with your gross income, which is the amount of money you have coming to you before you deduct anything. Your adjusted gross income is your gross income minus various deductions — as in, amounts you don’t have to pay taxes on.

As the amount left after your take all allowable deductions to your gross income, AGI is the amount of your total income that is taxable. This number forms the basis of your tax calculations for your federal return and most likely also your state return, including the credits and other deductions you can apply.  

Earned vs. Unearned Income 

It’s easy to confuse your gross income with your wages or salary. After all, most people’s wage earnings make up the bulk of their gross income. But gross income might include other income in addition to the figure you see on your paycheck. It’s made up not only of money you work for, called “earned income,” but also other sources of income, called “unearned income.”

Gross income provides a full picture of your income for a given tax year, including your salary, wages, tips, self-employment income, dividends, capital gains, interest, rental income, some retirement distributions, child support payments, most alimony payments received from 2019 onward, veterans' benefits, welfare benefits, workers' compensation, disability insurance income, Supplemental Security Income, royalties, and gambling winnings. 

The bigger number you see on your paycheck — the one you wish you could actually stick in your bank account but is slashed by withholdings and other deductions — is an element of earned income. That smaller, slashed number on the paycheck — the amount you actually pocket after deductions — is an earned-income portion of your adjusted gross income. 

Along with wages and salaries, self-employment earnings and tips are earned income. Unearned income, on the other hand, involves things you don’t work for directly, such as capital gains, rental income, and royalties. 

Deductions That Affect Your Adjusted Gross Income 

The deductions that you take out of your income in order to figure out your AGI are called “above-the-line” deductions. The name refers to the fact that all these deductions are ones you list on your tax form above the line for your AGI. They all go into calculating your AGI.

After you calculate your AGI, you’ll be able take further deductions — known, appropriately, as “below-the-line,” since the lines where you enter them are underneath the AGI line. The deductions you take above the line affect the amount and type of those you can claim below the line.  

A big difference between above-the-line and below-the-line deductions is that above-the-line deductions apply even if you don’t itemize your deductions on your tax return. It’s below the line where you decide whether to itemize all the deductions or claim the standard deduction instead. 

Common Above-the-Line Deductions

Accurately calculating AGI requires a good understanding of above-the-line deductions. Missing any of the deductions that can apply to your situation will mean paying more taxes than you owe. 

Here are the most common deductions taxpayers take to reduce their AGI.

  • Retirement plan contributions: Traditional 401(k) contributions are one of the most common above-the-line deductions that taxpayers take, which will be reflected in an employee’s W-2 if they’re contributing through an employer plan.

  • Self-employment tax: Taxpayers who are self-employed have to pay the employer and employee portions of Social Security and Medicare taxes, so these workers can deduct the employer-equivalent portion of self-employment tax. 

  • Self-Employment health insurance tax. Self-employed workers can deduct any fees or premiums they paid for health insurance, which can add up to a lot over the course of a year. 

  • Healthcare Savings Account (HAS) deductions: Deposits paid directly to an HSA can be deducted, though payments routed through an employer are already deducted on an employee’s W-2.

  • Alimony: The payer of alimony can deduct this amount only if those payments are made under a divorce or separation agreement executed before Dec. 31, 2018. Alimony is no longer a valid deduction since Jan. 1, 2019.

  • Moving expenses for military: Beginning in tax year 2018, the deduction for moving expenses can only be claimed in certain circumstances by military members.

  • Losses from property sales: A loss from the sale of rental or investment real estate can be deducted, but loss on the sale of property reserved for personal use cannot. 

  • Withdrawal penalties from some accounts: Prematurely taking money out of an account like a certificate of deposit (CD) will garner a fee, which taxpayers are permitted to deduct from their taxes. 

  • Academic fees and student loan interest: With a number of limitations, taxpayers can deduct school tuition, academic fees, and some types of student loan interest from their taxes. 

  • Jury duty pay turned over to your employer: A taxpayer who served on a jury and gave the jury duty pay to their employer to compensate for salary paid during that time can deduct that amount from taxes. 

  • Certain business expenses: Some business expenses in certain industries qualify as deductions, usually for performing artists, reservists, teachers, and some government officials. 

Using Your Adjusted Gross Income To Do Your Taxes

Now time to break out the calculator! 

Add up all your income from all sources to find your gross income. Next, calculate your applicable above-the-line deductions and payments, and then subtract the total from your gross income. Voilà: Your AGI.

Most taxpayers use IRS Form 1040 to report these calculations. Like all IRS forms, this one comes with detailed instructions, though they can sometimes be more confusing than enlightening. 

Once you’ve got your AGI nailed down, you can figure out whether it makes most sense to report itemized deductions or use the standard federal tax deduction. The total after you have taken away these below-the-line deductions is your final taxable income. 

Standard or Itemized Deductions? 

Taxpayers have the choice to deduct a single, set amount from their AGI or to deduct the total of a bunch of individual qualifying deductions, such as real estate taxes and charitable contributions, to arrive at their final taxable income. 

In many taxpayers’ cases, the standard deduction will result in a bigger deduction than itemizing will. This became especially true after the adoption of the Tax Cuts and Jobs Act in 2017, which almost doubled the standard deduction amounts. 

For the 2021 tax year, the standard deductions will be $25,100 for married couples filing joint returns; $12,550 for individual returns and married filing separately; and $18,800 for heads of households. The amount of the standard deduction can also vary with other factors such as blindness or age. 

Only a very significant list of itemized deductions, including such items as major medical bills, large charitable contributions, and/or hefty mortgage interest, would be likely to add up to more than these standardized deduction amounts.  

Adjusted Gross Income vs. Modified AGI (MAGI) 

If you thought AGI was complicated, you’re in for a treat. It’s also useful to know about modified adjusted gross income (MAGI), which is a further transformation of your AGI.

MAGI is a household’s AGI with any tax-exempt interest income and certain deductions added back in. MAGI takes account of things like foreign earned income, costs of higher education, and student loan interest to see if you qualify for various tax benefits, such as the ability to contribute to a Roth IRA and eligibility for the premium tax credit.

Can I Bury My Head Like an Ostrich? 

Taxes can be complicated, to say the least. Words like adjustments, modification, deductions, and itemization may well make your head spin. Don’t even get us started on the acronyms. 

The bad news is that you don’t have the option of sticking your head in the sand until it’s all over. As a taxpayer, you have no choice but to concern yourself with things like AGI and MAGI and Form 1040. 

But there’s good news too: You don’t have to do this alone. You can get professional help with Taxfyle. Our Pros will calculate your AGI for you and get the best possible return from your taxes. 

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Katherine Gustafson

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