Adjusted gross income is an amount that takes your total or gross income and makes certain adjustments to determine your income for certain tax relief conditions.
However, this leaves big questions unanswered. For example, what is the difference between adjusted gross income and taxable income? Which tax breaks count as adjustments and which count as deductions? And how can adjusted gross income affect your tax bill?
Adjusted Gross Income, commonly abbreviated as AGI, is one of the most important concepts for US taxpayers to understand. In this article, we’ll take a closer look at adjusted gross income, how yours is determined, and why it’s so important to you.
Understanding Adjusted Gross Income (AGI)
Before we go any further, there are three key income numbers you need to know: gross income, adjusted gross income, and taxable income.
- Gross revenue refers to the total amount of money you earn in a given year. It includes wages, salaries, tips, self-employment income, investment income, retirement income and other sources.
- Adjusted gross income is your gross income with some “adjustments”, as the name suggests. We’ll cover these adjustments in the next section, but they’re designed to give a better idea of how much money you’ve made in a year.
- Taxable income goes further and applies any tax deductions to which you are entitled. For example, mortgage interest is a deduction eligible taxpayers can claim to reduce their taxable income.
For purposes of calculating income, tax deductions are divided into two categories: income adjustments and deductions. Income adjustments are often referred to as “over the line” deductions, or items that can reduce your adjusted gross income. All other deductions are considered “below the line” deductions because they may reduce your taxable income but have no effect on your AGI. Because they reduce your AGI as well as your taxable income, above-the-line deductions are generally considered the more valuable of the two categories.
How does AGI affect your tax bill?
Here’s why it’s important to understand AGI. Adjusted gross income is the number used to qualify you for several tax benefits. For example, the maximum charitable deduction you can take in any given year is based on a percentage of your AGI. The ability to contribute to a Roth IRA is based on a slight variation in your AGI. And, in the context of the COVID-19 pandemic, the income cap for items such as the enhanced child tax credit was based on the AGI. Other AGI-based benefits include student loan interest deduction, adoption tax credit, and tuition tax credits.
There are many other examples, but the fact is that adjusted gross income is the number most commonly used to determine eligibility for income-based tax benefits. It should also be noted that the AGI is used by many states to calculate state income tax.
Examples of common adjustments
There are several income adjustments that can reduce your AGI in a given tax year. As of 2022, these include:
- Contributions to a tax-deferred qualified retirement plan, such as a traditional IRA.
- Contributions to a health savings account, or HSA.
- Educator expenses, up to the annual maximum.
- Interest on student loans, up to the maximum allowed.
- Half of the self-employment tax you paid.
- Self-employed health insurance premiums.
- Alimony payments.
- Moving expenses for members of the United States military.
- Employee business expenses, but only for certain groups such as armed forces reservists.
There are a few more, but these are the most common income adjustments.
How to Calculate Adjusted Gross Income (AGI)
The short answer is that you can calculate your adjusted gross income starting with your gross income, including income from employment, self-employment or self-employment, retirement income such as security payments social security and 401(k) withdrawals, unemployment benefits, investment income (such as stock sales or dividends), and any other source. Then you subtract any adjustments you are entitled to.
As an example, let’s say your gross income in 2022 is $100,000. You have the following adjustments:
- $5,000 in eligible contributions to a pension plan
- $1,000 in student loan interest
- $2,000 in contributions to an HSA
By taking your gross income of $100,000 and subtracting the $8,000 adjustments you are entitled to, you get an AGI of $92,000 for 2022.
Note that this is different from taxable income. Before the tax brackets are applied to your income, you subtract your other deductions, such as the standard deduction.
Finally, it’s also worth mentioning that if you use tax software, such as TurboTax or TaxAct, these calculations will all be done for you. But it’s still important to understand which deductions can reduce your AGI each year, as they can be extremely helpful in qualifying for other fiscal advantages.
Adjusted gross income vs modified adjusted gross income
There is a slightly different version of Adjusted Gross Income called amended adjusted gross income, or MAGI, which is technically the income number used for certain tax benefits. In a nutshell, MAGI calculations start with your AGI and add in some deductions, such as student loan interest.
As if it weren’t already complex enough, there is no single calculation formula for MAGI. The exact calculation procedure depends on the tax benefit for which it is calculated. For example, if you are trying to determine eligibility for Roth IRA contributions, you would add student loan interest, foreign earned income, foreign housing deductions, savings bond interest excluded and excluded employer adoption benefits (obviously, many of these do not apply to the majority of taxpayers). On the other hand, to determine net investment income tax liability, you would only add foreign adjustments.
As with AGI, if you are using tax software, your MAGI for each tax topic will be calculated for you, so there is no need to know the individual requirements. The key to remember is simply that some tax benefits and qualifications use a slightly different version of AGI.
Related investment topics
The bottom line
Adjusted gross income is not representative of the actual amount of income you received in a given tax year. However, it is a very important tax concept that is important for U.S. taxpayers to be aware of, as it determines eligibility for several valuable tax benefits, as well as liability for certain taxes, such as net investment income. Although you’re unlikely to have to calculate your own AGI by hand, knowing how it works can help you learn how to spread your money around to get as many tax benefits as possible.
The Motley Fool has a disclosure policy.