In its most basic form, adjusted gross income (AGI) is the amount that you earned over the course of the previous year with select deductions and allowances removed to determine your taxable income. AGI is used by the federal and state governments to determine your tax liability based on your total income and deductible costs over the previous year.
Calculating AGI correctly is important to ensure that you don’t overpay or underpay on your taxes. In this article you will learn more about adjusted gross income and how you can use this number during tax season.
Adjusted Gross Income Explained
Simply put, AGI is your total income from all sources minus relevant deductions based on specific costs you may have had over the past year. AGI is used to calculate your taxable income, as opposed to your total income.
Federal and state governments calculate AGI by adding up your total income over the course of the year (which includes income from jobs, alimony payments received, rent payments received, and so on) and then subtracting relevant expenses as outlined by your tax guidelines.
While AGI is calculated on your federal taxes, most states also base your total tax bill on a calculation that uses your adjusted gross income.
How to Calculate Adjusted Gross Income
Your gross income is the sum of all the money you earn in a year from every source of income you have, including your job. A few sources of taxable income include:
- Your Wages
- Income from Properties You Rent to Others
- Retirement Distribution from Pensions and Social Security Payments
- Alimony Payments You Received from a Former Spouse
- Profit from the Sale of a Property
- Unemployment Compensation
For example, if you earn $40,000 per year at your full-time job but also make $12,000 per year through a rental property, then your gross income would be $52,000.
IRS has a list of the requirements for possible deductions from gross income broken into categories. A few of these categories include:
- Medical and Dental Expenses
- Charitable Contributions
- Business Use of Home and Car
- Work-Related Education Expenses
- Disaster or Theft Losses.
If you’re not sure how to account for your various forms of income and adjustments, the federal government will include (or make available online) instructions and workbooks that should be able to help you.
If you file your taxes online, various software tools should be able to calculate AGI for you as well. You will answer a few basic questions and about your income, adjustments and exemptions to determine your AGI. Since roughly 80% of people file their taxes online, more people rely on these software packages to help them calculate their AGI.
What Are Some Adjustments You Could Qualify For?
There are several adjustments that you can subtract from your gross income to calculate your AGI. They vary based on the events in your life over the course of the year and changes in your financial status. A few of the most common ones include:
- Some retirement contributions, like IRA accounts and qualified plans.
- Alimony that you paid out to a former spouse.
- Jury duty pay that you turned over to an employer.
- Losses incurred during a sale of a property.
- Any penalties from early-withdrawal of savings from a financial institution.
- Half of the self-employment tax. This allows people who are self-employed to adjust for the employer-equivalent of the self-employment tax, specifically the Social Security and Medicare taxes.
- Healthcare savings account (HSA) contributions. Single-person taxpayers can contribute up to $3,450, or $6,900 for a high-deductible family health plan. Self-employed workers can also deduct their health insurance premiums.
- Moving expenses for military personnel. As part of the 2018 tax law updates, only active-duty military personnel who are moving because of military orders are able to deduct moving expenses on their taxes.
- School tuition, fees, and student loan interest, though there are some exceptions.
- Certain business-related expenses based on your field of employment. This includes those working as reservists, performing artists or government officials paid on a fee basis. These deductible expenses include parking fees, tolls, and travel.
- Educator expenses. Educators can deduct up to $250 in expenses spent on the classroom, including money spent on books, supplies, and professional development courses.
As you can see, it’s possible that your AGI will be much less than your gross income if you paid a lot of student loan interest, paid significant alimony, or were able to make business-related expenses. This is a way to avoid being taxed on money that you were legally obligated to take (such as alimony) or to take into account expenses for pursuits like going to school or developing a business.
For certain exemptions or deductions, the IRS requires specific forms of documentation. In some cases, like the section on charitable giving, the IRS requires specific forms and receipts proving that the amount given is correct. These itemized deductions are less common amongst tax filers, with only 10% of all filers opting to itemize in 2018.
How Else is Adjusted Gross Income Used?
Adjusted gross income is predominantly used for tax purposes, which may lead you to think that it’s not important outside of that context. However, there is another reason to pay attention to your adjusted gross income outside of tax season: AGI is taken into consideration in major lending decisions, including mortgage applications. Lenders want to make sure you can make the set monthly payments, which is why they use your AGI as a base to determine your income.
Knowing your AGI can help you better understand your financial situation – from estimating your taxes to understanding how banks view your lending risk.
Learn More About Income Types
By understanding adjusted gross income and other tax terminology, you can better understand what you earn in a year and feel more confident when filling out your taxes. You can also use your AGI to assess your potential mortgage affordability and loan prospects. This can empower you to make sound financial decisions.
Learn more about tax terms and mortgage options through the personal finance section of our resources. You can use our content to answer all of your questions about credit, complex financial terms, and economic trends.