Adjusted gross income (AGI) is an individual’s total gross income minus certain deductions. It is used to calculate taxable income, which is AGI minus allowances for personal exemptions and itemized deductions. For most individual tax purposes, AGI is more relevant than gross income.
Here are some of the most common deductions that can be used to reduce AGI:
- Retirement savings contributions: Contributions to traditional and Roth IRAs, 401(k)s, and other retirement savings plans can be deducted from AGI.
- Student loan interest: Interest paid on student loans can be deducted from AGI.
- Alimony payments: Alimony payments made to a former spouse can be deducted from AGI.
- Health insurance premiums: Self-employed individuals can deduct the premiums they pay for health insurance.
- Educator expenses: Teachers and other educators can deduct certain expenses related to their work, such as classroom supplies and mileage.
AGI is used to determine eligibility for many tax credits and deductions, including the Earned Income Tax Credit, the Child Tax Credit, and the American Opportunity Tax Credit. It is also used to calculate the amount of Social Security and Medicare taxes that an individual owes.
If you are trying to reduce your tax liability, there are a number of things you can do to lower your AGI. You can contribute to retirement savings plans, pay off student loans, make alimony payments, and deduct other eligible expenses. By lowering your AGI, you can lower your taxable income and save money on taxes.
What to Know About Adjusted Gross Income
Here are some things to keep in mind about AGI:
- AGI is not the same as taxable income: Taxable income is calculated after AGI is adjusted for personal exemptions and itemized deductions.
- AGI is used for a variety of tax purposes: AGI is used to determine eligibility for tax credits and deductions, calculate the amount of Social Security and Medicare taxes that an individual owes, and set the income limits for certain tax brackets.
- AGI can be affected by changes in income or deductions: If your income or deductions change, your AGI may also change. This can impact your tax liability, so it is important to keep track of your AGI and any changes that may occur.
How to Calculate Adjusted Gross Income
Determine Total Income:
Begin by adding up all sources of income you received throughout the tax year. This includes wages, salaries, tips, self-employment income, rental income, interest, dividends, capital gains, retirement distributions, and any other taxable income.
Identify Above-the-Line Deductions:
Identify any deductions or adjustments that you can claim above the line, which means they are subtracted from your total income to arrive at AGI. These deductions are often listed on the first page of Form 1040 or can be found in the instructions. Common above-the-line deductions include contributions to retirement plans, self-employment taxes, health savings account (HSA) contributions, educator expenses, student loan interest, and alimony paid (for divorces finalized before 2019).
Subtract Above-the-Line Deductions:
Subtract the total amount of your above-the-line deductions from your total income. This gives you your AGI.
AGI = Total Income – Above-the-Line Deductions
Determine Adjustments or Itemized Deductions:
Depending on your tax situation, you may have additional deductions or adjustments that can be claimed either as itemized deductions or as specific adjustments on Schedule 1 of Form 1040. These deductions may include state and local taxes, mortgage interest, charitable contributions, medical expenses (above a certain threshold), and other eligible expenses. You can choose to take either the standard deduction or itemize your deductions based on what benefits you the most.
Subtract Itemized Deductions or Standard Deduction:
Subtract your itemized deductions or the standard deduction (whichever applies to your situation) from your AGI. This calculation gives you your taxable income.
Taxable Income = AGI – Itemized Deductions or Standard Deduction
What Are Examples of Adjustments in Taxes?
The adjustments to income listed on Schedule 1 have a direct impact on reducing your taxable income.
To illustrate this, let’s consider an example provided by Brian Copeland, partner and director of financial planning with Hightower Wealth Advisors in St. Louis, Missouri. Suppose you have a salary of $50,000 and contribute $5,000 to a retirement account, such as a traditional 401(k) or IRA. This contribution would lower your Adjusted Gross Income (AGI) to $45,000.
Once your AGI is calculated, there are further deductions that can be made before reaching your taxable income. These deductions include:
- Standard or Itemized Deduction: Taxpayers can choose to claim either the standard deduction or itemize their deductions based on their specific situation. The standard deduction is a predetermined amount set by the IRS, while itemized deductions include expenses such as state and local taxes, mortgage interest, charitable contributions, and medical expenses above a certain threshold.
- Charitable Contributions: Taxpayers who claim the standard deduction can still deduct charitable contributions of up to $300 for single taxpayers or $600 for married couples filing jointly, which can further reduce their taxable income.
- Qualified Business Income Deduction: For individuals with income from pass-through businesses, such as sole proprietorships, partnerships, or S-corporations, there may be additional deductions available through the Qualified Business Income Deduction.
The resulting taxable income is then used to determine the amount owed to the government. Taxpayers who are eligible for tax credits, such as the child tax credit or earned income tax credit, can apply those credits to reduce the final tax bill owed.
How Do I Reduce AGI?
Taxpayers often wonder how they can lower their taxable income before the end of the year. According to Copeland, one of the most effective ways to achieve this is through retirement contributions.
In 2022, workers can contribute up to $20,500 to a 401(k) account or $6,000 to an IRA. For individuals aged 50 and older, catch-up contributions are also allowed. Contributions made to traditional retirement accounts within these limits will reduce the taxpayer’s Adjusted Gross Income (AGI) and, consequently, their taxable income.
Retirees have an additional option to lower taxes through qualified charitable distributions (QCDs). Once individuals reach age 72, they are required to take minimum distributions from their traditional retirement accounts. These distributions add to their taxable income. However, by making a QCD, which involves directing the distribution directly to a charity, the distribution amount is excluded from the taxpayer’s AGI. This provides a tax benefit while supporting charitable causes. It’s important to consult with a finance professional for guidance on the QCD process.
Other strategies to reduce AGI include contributing to health savings accounts (HSAs), deducting student loan interest, and claiming expenses related to qualified rental properties.
Lowering your AGI generally has few downsides and should not impact your Social Security benefits. However, some lenders might consider your AGI when evaluating loan applications.
Joseph advises that reducing AGI could potentially affect borrowing ability, but Renn notes that if lenders observe a low AGI due to substantial retirement contributions, it may not negatively impact loan approval chances. Lenders might assume that the taxpayer could adjust their contributions to allocate funds for loan payments if necessary.
>> READ: What is Food Stamp and Who is Eligible?
What’s the Difference Between AGI and Modified Adjusted Gross Income, or MAGI?
AGI stands for Adjusted Gross Income, while MAGI stands for Modified Adjusted Gross Income. Although both terms are related to income calculations for tax purposes, they have different purposes and implications. Here’s a breakdown of the difference between AGI and MAGI:
Adjusted Gross Income (AGI)
AGI is a key figure in determining an individual’s taxable income. It is calculated by subtracting specific deductions known as above-the-line deductions from the individual’s total income. These deductions include items such as contributions to retirement plans, self-employment taxes, health savings account (HSA) contributions, and educator expenses. AGI serves as the starting point for calculating the individual’s taxable income and is used to determine eligibility for certain tax credits, deductions, and other tax-related benefits.
Modified Adjusted Gross Income (MAGI)
MAGI is a modified version of AGI that includes further adjustments to income. MAGI is often used to determine eligibility for certain tax benefits, deductions, and credits, as well as for various financial assistance programs. The adjustments made to AGI to arrive at MAGI can vary depending on the specific purpose or program requirements.
Common adjustments include adding back certain deductions, such as student loan interest or tuition expenses, that were previously subtracted in the AGI calculation. Additionally, MAGI can include items such as tax-exempt interest, certain foreign income, and deductions for contributions to retirement plans or self-employed health insurance.
MAGI is frequently used in determining eligibility for tax provisions and benefits like the premium tax credit for health insurance under the Affordable Care Act, eligibility for certain deductions (e.g., IRA deductions), and qualification for certain income-based assistance programs like Medicaid, Children’s Health Insurance Program (CHIP), and subsidies for marketplace health insurance plans.
