What is adjusted gross income?

ByMunyaradzi Mafaro

Adjusted gross income (AGI) is the amount you make in a year minus some specific deductions the IRS allows. It’s the starting point for calculating how much tax you need to pay. Your AGI affects many parts of your tax return, from qualifying for certain tax credits to determining how much you can deduct.

How AGI Works

You start with all the money you made during the year. This includes your work wages, business money, investment earnings, and other income. Then, you subtract certain deductions the IRS allows before calculating your tax. These subtractions give you your adjusted gross income.

Your AGI appears on your Form 1040 tax return. The IRS uses this number to determine if you can take other tax breaks. A lower AGI often means you can get more tax benefits.

The Difference Between Gross Income and AGI

Gross income means all the money you make before taking away any deductions. It includes your salary, tips, business profits, rental income, dividends, and gambling winnings. AGI is left after you remove specific deductions from your gross income.

Common AGI Deductions

Student Loan Interest

You can subtract up to $2,500 from the interest you paid on student loans. This helps many people who are paying back the money they borrowed for college. You don’t need to itemize your deductions to get this benefit.

Self-Employment Tax

You can deduct half of your self-employment tax if you work for yourself. This tax covers Social Security and Medicare contributions that self-employed people must pay. Employees usually split these costs with their employers, but self-employed people pay the full amount.

Health Insurance for Self-Employed People

Self-employed people can also deduct what they pay for health insurance for themselves and their families. This includes medical, dental, and long-term care insurance premiums.

IRA Contributions

The money you put into a traditional IRA can lower your AGI. For 2024, you can contribute up to $7,000 if you’re under 50. If you’re 50 or older, you can add an extra $1,000 as a catch-up contribution.

Educator Expenses

Teachers and other educators can deduct up to $300 they spent on classroom supplies. This helps teachers who often spend money on things their students need.

Moving Expenses for Military

Active-duty military members who move because of military orders can deduct their moving costs, which include transportation, storage, and travel expenses.

Alimony Payments

People who pay alimony for divorces finalized before 2019 can deduct these payments from their gross income. However, for divorces after 2018, alimony payments don’t affect AGI.

Why AGI Matters

Tax Credits and Deductions

Many tax breaks depend on your AGI. For example, you might only get certain credits if your AGI is below a certain amount. Look at your AGI for the child tax credit, education credits, and retirement savings contributions credit.

Healthcare Costs

Your AGI affects how much you can deduct for medical expenses. You can only deduct medical costs that are more than 7.5% of your AGI. A lower AGI means you can deduct more medical expenses.

College Financial Aid

Schools use your AGI to decide how much financial aid your family can get. A lower AGI might help you qualify for more assistance. This includes grants, loans, and work-study programs.

Medicare Premiums

If you’re on Medicare, your AGI from two years ago affects how much you pay for Part B and Part D coverage. Higher AGIs mean higher premiums.

Modified Adjusted Gross Income (MAGI)

Sometimes, the IRS uses Modified Adjusted Gross Income (MAGI). MAGI starts with your AGI and adds back some deductions. Different tax benefits use different versions of MAGI.

Common MAGI Adjustments

You might need to add back:

  • Student loan interest deduction
  • Foreign earned income exclusion
  • Tax-exempt interest
  • IRA contribution deductions

MAGI matters for things like:

  • Roth IRA contribution limits
  • Premium tax credits for health insurance
  • Student loan interest deduction limits
  • Rental loss allowances

Strategies to Lower Your AGI

Retirement Account Contributions

Putting money in a traditional 401(k) or IRA lowers your AGI. This can help you qualify for more tax benefits. Your employer takes this money out of your paycheck before calculating your income.

Health Savings Account Contributions

You can put money in a Health Savings Account (HSA) if you have a high-deductible health plan. These contributions lower your AGI. For 2024, you can contribute up to $4,150 for individual coverage or $8,300 for family coverage.

Timing Your Income

Sometimes, you can choose when you receive income. If you’re close to qualifying for a tax benefit, you might want to delay some income until the next tax year. This could lower your current year AGI.

State Tax Considerations

States often use federal AGI as a starting point for state taxes. Then, they make their adjustments. Some states add back certain federal deductions. Others allow extra deductions. You need to check your state’s rules to understand how AGI affects your state taxes.

Common Mistakes to Avoid

Missing Deductions

Some people forget to claim all their AGI deductions. This means they pay more tax than they need to. It’s important to keep good records and understand what deductions you can take.

Mixing Up AGI and Taxable Income

AGI is not the same as taxable income. Taxable income is left after you take your standard deduction or itemized deductions from your AGI. You pay taxes on your taxable income, not your AGI.

Not Planning Ahead

AGI affects many parts of your taxes and financial life. Planning can help you make smart decisions about retirement contributions, HSA contributions, and timing your income.

Record Keeping

Keep records of everything that affects your AGI. This includes:

  • W-2 forms from employers
  • 1099 forms for other income
  • Receipts for deductible expenses
  • Records of retirement account contributions
  • Documentation for educational expenses

Good records make it easier to calculate your AGI correctly and prove your deductions if the IRS asks questions.

Getting Help

Tax rules about AGI can be complicated. Many people work with tax professionals or use tax software to calculate their AGI correctly. The IRS website also has detailed information about AGI and available deductions.

Professional tax help can be especially valuable if you:

  • Are self-employed
  • Have multiple sources of income
  • Make retirement account contributions
  • Want to lower your AGI to qualify for tax benefits

Changes in Tax Law

Tax laws change often. Congress can add or remove AGI deductions. They can also change income limits for tax benefits. Stay informed about tax law changes that might affect your AGI. The IRS updates its website with new tax rules each year.

Munyaradzi Mafaro is a music enthusiast and he also likes to tackle topics of business, productivity, and the possibilities for growth in the digital world.