Adjusted Gross Income (AGI)
Definition:
Adjusted Gross Income (AGI) is a key figure used in the United States tax system. It represents an individual’s total income minus certain adjustments, but before standard or itemized deductions are applied. AGI is a crucial measure because it determines eligibility for various tax credits and deductions, and it is used to calculate taxable income. It is one of the first steps in determining how much an individual will owe in taxes for the year.
How AGI is Calculated:
To calculate your AGI, you start with your Gross Income (which includes all income sources such as wages, dividends, business income, retirement distributions, and rental income). From this amount, you subtract allowable adjustments (sometimes called "above-the-line" deductions). These adjustments include expenses like retirement account contributions, student loan interest, and tuition payments.
Formula:
AGI=Gross Income−Adjustments to Income
Example:
Let’s say a taxpayer has the following financial situation:
Gross Income:
Salary: $80,000
Dividends: $2,000
Business Income (side gig): $5,000
Total Gross Income = $80,000 + $2,000 + $5,000 = $87,000
Adjustments to Income:
Traditional IRA Contribution: $3,000
Student Loan Interest Paid: $1,000
Total Adjustments = $3,000 + $1,000 = $4,000
Using the formula:
AGI=87,000−4,000=83,000
So, the taxpayer’s Adjusted Gross Income (AGI) is $83,000.
Examples of Adjustments to Income:
Some common adjustments (also called "above-the-line deductions") include:
Retirement Contributions: Contributions to a traditional IRA or 401(k) plan are deductible, reducing your AGI.
Student Loan Interest: You can deduct up to $2,500 in interest paid on qualified student loans.
Tuition and Fees Deduction: A deduction of up to $4,000 for qualified tuition and fees, depending on your income.
Health Savings Account (HSA) Contributions: Contributions to an HSA can be deducted from gross income, lowering your AGI.
Self-Employment Deductions: If you are self-employed, you can deduct business expenses such as office supplies and part of your self-employment taxes.
Alimony Payments: For divorce agreements finalized before 2019, alimony payments may be deductible.
Moving Expenses for Active Duty Members: If you’re in the military and move due to a permanent change of station, you can deduct moving expenses.
Why AGI is Important:
Taxable Income Calculation: After determining your AGI, you subtract either the standard deduction or itemized deductions to calculate your taxable income. This is the amount on which you’ll pay taxes.
Eligibility for Tax Benefits: AGI is used to determine eligibility for various tax credits and deductions, such as:
Child Tax Credit
Earned Income Tax Credit (EITC)
Education Tax Credits (like the American Opportunity Credit)
Medical Expense Deductions (based on a percentage of AGI)
Deduction for Charitable Contributions (for those who itemize)
Phaseouts of Tax Benefits: As your AGI increases, certain tax credits and deductions phase out. For example, the Child Tax Credit begins to phase out when your AGI exceeds a certain threshold, and many other tax benefits have income limits that reduce the benefit amount as your AGI grows.
Impact on Social Security Benefits: Higher AGI may also affect the taxation of Social Security benefits. If your AGI exceeds certain thresholds, a portion of your Social Security benefits may be taxed.
AGI vs. Taxable Income:
While AGI is an important number for determining eligibility for tax credits and deductions, it’s not the amount you pay taxes on. Once you’ve calculated your AGI, you will subtract either the standard deduction (for most taxpayers) or itemized deductions (for those with significant deductible expenses) to arrive at your taxable income. This is the amount on which you’ll actually pay income taxes.
For example:
Standard Deduction for a single filer in 2024 is $13,850.
If your AGI is $83,000, your taxable income after applying the standard deduction would be:
Taxable Income=AGI−Standard Deduction
Taxable Income=83,000−13,850=69,150
This $69,150 would be the income on which you pay taxes.
AGI and State Taxes:
Some states use AGI as a starting point to calculate state income taxes, but they may allow additional deductions, exemptions, or credits. It’s important to check with your state tax authority to understand how AGI affects your state taxes.
AGI and Other Financial Calculations:
Debt-to-Income Ratio: Lenders often use AGI as a factor in determining a borrower’s ability to repay a loan. This ratio is useful for mortgage lenders when deciding how much they are willing to lend.
Retirement Savings Strategy: AGI can impact your ability to contribute to certain retirement accounts. For example, if your AGI is below a certain threshold, you can deduct contributions to a traditional IRA. On the other hand, higher AGI may disqualify you from contributing to a Roth IRA or may limit the deductible contribution to a traditional IRA.
AGI and Tax Filing:
When preparing your tax return, you’ll find your AGI on Line 11 of the IRS Form 1040. Your AGI is the starting point for calculating your final taxable income and the amount of taxes you owe or refund you will receive. Ensuring that you account for all allowable adjustments to income can help lower your AGI and, potentially, reduce your tax liability.
Conclusion:
Adjusted Gross Income (AGI) is an essential concept in the U.S. tax system, representing an individual’s gross income after specific deductions are subtracted. AGI plays a crucial role in determining taxable income, eligibility for various tax benefits, and even the taxation of Social Security benefits. By understanding AGI and its components, taxpayers can make more informed decisions about their taxes and potentially reduce their tax liability by taking advantage of available deductions.