Adjusted Gross Income (AGI)

When the IRS determines how much an individual owes in taxes, they don't look at one's total income. Instead, they use a metric called adjusted gross income (AGI). This figure is one's total annual income minus some adjustments (which we'll get to later). 

The government also uses this metric to determine if people qualify for some government assistance programs, tax credits, and other tax considerations. 

Some state governments use this figure too, but they may change some of the adjustments to calculate it. 

Explanation: It is the figure that the IRS uses to calculate the amount of taxes you owe to the federal government for the year. It subtracts adjustments from the gross income. 

It will never be more than your total gross income. In some cases, it can be lower. 

These adjustments can include business expenses, student loan interest payments, and IRA deductions. In addition, it also sets upper limits on tax credits and reductions. 

Tax credits and deductions can increase your tax refund or reduce the taxes you owe to the government. This means that lowering it is one way to reduce the federal taxes you pay. 

Depending on a person's filing status, that individual may be subject to an AGI limit, a dollar amount limiting the deductions you can take. This usually applies to people who have higher incomes.

Some U.S. states may use this from federal tax returns to determine how much individuals owe in state income taxes. Some different deductions are subtracted at the state level for AGI. 

Understanding the concept

It is calculated by subtracting adjustments from your gross income that the IRS permits as one's AGI decreases through these qualified deductions, and one ends up paying fewer taxes. 

It is one of the most important figures when it comes to tax returns and is probably the most important figure on your Form 1040. This figure is responsible for determining how your taxes are processed, the benefits you're eligible to receive, and how much you owe in income taxes. 

For example:

• Say you make $90,000 a year and pay a federal income tax rate of 24%.
• However, you can deduct $6,000 from that through some of the qualified deductions.
• Now it is $84,000. This would put you in the 22% federal tax bracket. 

Just like that, you are now paying less tax!

So many people find it ideal to try to lower it as much as possible, so they are subject to a lower tax bracket, resulting in a lower tax rate.

The federal government splits individuals into different tax brackets in the United States based on their income (or AGI as we know it now). There are seven different tax brackets, ranging from an income of 0 to $500,000 or more. 

People in the higher tax bracket, meaning they have a higher income, will pay more taxes and have a higher tax rate than someone in a lower bracket.

Your income will be spread across multiple tax brackets if you are a high earner. So if you make $50,000, different portions of your income will be taxed at different rates:

• $0 - $10,275 will be taxed at a 10% rate

• $10,276 - $41,775 will be taxed at a 12% rate.

• And $41,776 - $50,000 will be taxed at a 22% rate.

So, not all of your income will be taxed at 22%, but a portion of it will. 

Terms you need to know:

• Gross Income - Gross income includes wages, dividends, capital gains, business income, and other forms of income.

• Taxable Income - AGI minus either the standard deduction or the total of itemized deductions. Whatever is greater of these two and the qualified business income deductions if applicable. Taxable income determines your tax bracket.

• Modified Adjusted Gross Income (MAGI) - AGI with some deductions added back. MAGI determines your eligibility for certain deductions, credits, and retirement plans. 

Calculating your adjusted gross income

Luckily enough, with new technology, it is easier to calculate. Just download the software, which will automatically calculate once you input numbers. 

If you don't have access to software or want to calculate it by hand, here's what you need to do:

First, find your income statement: 

To begin the calculation, you must gather all your income statements. This will include your W-2 for your salary and wages, anything that may list income from self-employment, and any income you have reported on various 1099 forms.*

These are some examples of taxable income:

• Income from a business

• Capital Gains 

• Severance Pay

• Court awards and damages

• Jury duty pay

• Hobby income

• Interest and dividends

• Winnings from the lottery, gamblings, awards, or prizes 

The next step is to calculate your total annual income:

After you have your income statements ready, it's time to determine your total annual income. Add up all the revenues from the various income statements to see how much income you bring home in a year. 

You are fortunate if you have a salary because that will be the bulk of your income already available. 

If you work by an hourly wage, then you can multiply the salary by the number of hours you work per week and then multiply that number by 52, since there are 52 weeks in a year, to receive your total income from that job.

If you're married and filing a joint tax return, you must include your partner's income and bonuses, as this form is for the entire household. 

The next step is to figure out the number of deductions that apply to you: As mentioned above, it requires you to subtract deductions from your annual income. 

If filing jointly, you'll need to add up all the deductions that apply to you (and your spouse). These deductions can change every year, so calculate them every year. 

Here are some of the most common deductions:

• Educator Expenses

• Costs incurred by military reservists, performing artists, and fee-based government officials 

• Health savings accounts (HSAs)

• Moving expenses for members of the military

• Several self-employment costs (Ex. retirement plan contributions, health insurance premiums, and half the self-employment tax reported on Schedule SE)

• Penalty on early withdrawal of savings

• Student loan interests

• Tuition and other educational expenses

• IRA deduction

• Alimony paid

Once you determine which deductions apply, add them all up. The last step is to subtract your deductions from your total annual income. 

By this point, you should have your total annual income and the total amount of deductions that apply to you. The last thing to do is subtract the deductions from your total income, and you will receive your adjusted gross income. 

The formula to calculate looks like this: 

Gross Income - Adjustments = AGI

Adjusted gross income vs. modified adjusted gross income

It is a common mistake for people with little experience doing tax returns to use AGI, where MAGI is applicable. This is because there's a difference between the two figures. 

Modified Adjusted Gross Income is another figure government programs use. It is calculated by adding some adjustments back to your AGI. Many of these adjustments are rare, so your AGI and MAGI could be identical.

MAGI determines whether you qualify for any tax deductions or credits. It is also used to determine whether or not your contributions to an individual retirement plan are deductible.  

It can also be used to determine eligibility for things like deducting contributions to a traditional IRA or the ability for an individual to contribute to a Roth IRA.

A traditional IRA is an individual retirement account that allows people to contribute pre-tax and after-tax dollars. Your money grows tax-deferred, and when you elect to withdraw money from your account after 59 ½, the money is taxed as current income. 

A Roth IRA is a little different. This account takes after-tax dollars. Since your contributions are post-taxed, the money grows tax-free. So after the age of 59 ½, you can take out money tax and penalty-free. 

So the most significant difference between the two retirement accounts is when the money is taxed. A traditional IRA is taxed when you take out money after the age of 59 ½. On the other hand, the money in a Roth IRA is taxed before it enters the account, so when you withdraw cash, it's tax-free. 

Examples

Some of the examples are as follows:

1. Example of How AGI Affects Deductions:

Let's say that you got into a pretty bad car crash and had major injuries, resulting in a large number of expenses. Insurance didn't reimburse these expenses, so you decided to itemize your deductions. 

Expenses that exceed 7.5% of your AGI can be deducted. 

So if you have an AGI of $200,000 and have $20,000 in medical expenses, you can deduct anything over $14,000. This would mean that $6,000 is deductible from your AGI. 

If you had an AGI of $75,000 and the same amount of medical expenses, you could deduct $14,375. 

Having a lower number can lead to an increase in deductions. 

2. Examples of how to calculate adjusted gross income for a married couple:

Let's say, Liam and Lauren, a married couple, are filing their taxes jointly. Liam was fortunate to earn $150,000 this year, while Lauren earned $90,000. If we add up both incomes, we get a household income of $240,000. 

Now it's time to figure out their deductibles.

Liam and Lauren both have student loan payments. Liam puts money in his IRA, and Lauren is a teacher and has to pay for some of the supplies that the school doesn't offer. They add up their deductions, and it comes out to $30,000. 

To find it, they must subtract these deductions ($30,000) from their household income of $240,000.

This would result in a household AGI of $210,000. 

3. Example of how to calculate adjusted gross income for an independent:

Jake is filing his tax returns for 2022 and wants to calculate his AGI. After everything was considered, including salary and bonuses, Jake determined that he would make about $78,000 in 2022. 

Jake now looks at the deductibles that apply to him. Jake is recently divorced and paid $8,000 in alimony. He also puts $4,000 into an IRA account and $3,000 into a health savings account (HSAs).

After adding up all the deductibles, he determines the amount to be $15,000.

He then subtracts the deductibles from his annual income to get an AGI of $63,000. 

Researched & Authored by Alexander

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Amortization
• Book Value
• Depreciated Cost
• Net Book Value
• Retained Earnings