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For tax purposes, there are multiple levels of income, including adjusted gross income.
Calculating your adjusted gross income, or AGI, is the first step toward determining how much tax you’ll pay. You’ll reach the figure by taking your gross income and subtracting certain adjustments allowed by the IRS.
Once you know your AGI, you can start calculating your taxable income — that’s the amount of your income that could be subject to tax. Taxable income determines your tax bracket and your tax rate. Your AGI can also help determine your eligibility for certain tax deductions and credits.
In this article, we’ll look at AGI, how it’s calculated and what to do with it.
What is adjusted gross income?
To define adjusted gross income, you first need to understand gross income. Gross income is all the income you receive in a year, and it can include wages an employer pays you, money you made working for yourself, interest on financial accounts and other sources of personal revenue or gain.
Adjusted gross income is your gross income minus adjustments. When you’re filling out your Form 1040 in order to file your tax return, the section marked “Income” helps you calculate your gross income. On the 1040-EZ, that section also helps you calculate adjusted gross income.
Once you have your gross income, you’ll subtract from it any adjustments you qualify for. These adjustments are known as “above-the-line” adjustments and they help you calculate your AGI.
Here are some useful examples of adjustments you may qualify for.
Eligible educators can deduct up to $250 of qualified and unreimbursed expenses. Those expenses include books, supplies, equipment, materials and professional-development courses.
Certain business expenses
If you’re a reservist, performing artist or a government official paid on a fee basis, you can count certain expenses for your job that are ordinary and necessary and aren’t reimbursed. A few examples include parking fees, tolls, and travel.
Health savings account contributions
Taxpayers with a single-person high-deductible health plan can contribute up to $3,450 to a health savings account. If it’s a family health plan, you can contribute up to $6,900.
You can count certain moving expenses if you’re an active-duty servicemember and are moving by military order to a permanent change of station. Some of these expenses include travel and lodging, along with transportation for your personal belongings.
Tax deductions vs. tax credits: The difference
Both tax credits and tax deductions can help reduce the amount of tax you owe, but they do so in different ways.
A tax deduction reduces the amount of income you pay tax on — and it could mean you pay less in taxes, too. But a tax credit is a dollar-for-dollar reduction in the amount of tax you owe, so a tax credit can potentially have a bigger effect on your final tax bill than a deduction.
If you own a business, you can take an adjustment of the employer-equivalent of the self-employment taxes you’ve paid during the year. Specifically, this includes Social Security and Medicare taxes.
Contributions to self-employed SEP, SIMPLE and qualified plans
Business owners can also take an adjustment for contributions to any of these retirement plans, plus contributions made for employees.
Self-employed health insurance premiums
If you’re self-employed, you may have the option to take an adjustment of the amount you paid during the year in health insurance premiums for you, your spouse and qualifying dependents.
Penalty on early withdrawal of savings
If you paid any early-withdrawal fees or penalties on a certificate of deposit or similar account, you can take an adjustment of the amount you paid to the bank or credit union.
You can take an adjustment for alimony payments you’ve made to a former spouse — but only if the alimony occurred on or before Dec. 31, 2018.
You can lose the adjustment for alimony paid before that date as well if the agreement is later modified and specifically updated to note that the new rule applies.
Individual retirement account contributions
If you contributed to a traditional IRA during the year, you might be able to take an adjustment for some or all your contributions. The amount you can subtract will depend on your modified adjusted gross income, or MAGI, (more on that in a bit).
Student loan interest
Some student loan borrowers can take an adjustment of some or all they’ve paid in interest on their loans throughout the year, up to $2,500. Your adjustment may be limited based on your filing status and modified adjusted gross income.
Understanding the other levels of income
We’ve already discussed three types of income in depth: gross income, adjusted gross income and taxable income. There are, however, more you might come across when you’re filing your taxes.
- Net income: If you’re a business owner, your taxable income may be determined on your net income after expenses, rather than on your gross income.
- Modified adjusted gross income: Also called MAGI, this is your AGI plus some deductions added back in. Your MAGI is another number the tax code uses to determine if you qualify for certain tax breaks.
What to do with your AGI once you know it
Once you know your AGI, you can use it to find out if you can take advantage of certain tax credits and deductions to reduce your taxable income.
Keep in mind, though, that some deductions and credits, including the child tax credit, may be based on your MAGI instead.
To calculate your MAGI, take your AGI and add back in the following adjustments:
- IRA deduction
- Student loan interest deduction
- Domestic production activities deduction
- Foreign earned income exclusion
- Foreign housing exclusion or deduction
- Exclusion of qualified savings bond interest
- Exclusion of employer-provided adoption benefits
Once you decide whether you’ll take the standard deduction or itemize your deductions, you’ll subtract that total deduction amount from your AGI to get your taxable income.
If your state has an income tax and you need to file a state return, you’ll typically also use your AGI as the starting point for your state return. You’ll then apply any state-based deductions, adjustments and credits to get your state taxable income.
Your adjusted gross income is a key figure to know when you’re filing your tax return. Not only is it important to know how to calculate it, but it’s also a good idea to know which tax breaks may be limited based on your AGI.
And there’s another reason why knowing your adjusted gross income is so important — if you do your own taxes and e-file, you’ll need to know your 2017 AGI in order to validate your return. Credit Karma Tax®, the free online tax-preparation service, can furnish your prior year’s AGI for you if you used it to file your 2017 federal income tax return.
Rachel Weatherly is a tax product specialist with Credit Karma Tax®. She studied accounting and finance at Western Carolina University and has also worked as a tax analyst. You can find her on LinkedIn.