When it comes to personal finance, acronyms abound. You’ve probably come across HSAs, COBRAs, COLAs, ETFs, and APRs, to name a few. But when considering your tax situation for the year, there’s one acronym you need to understand. That is AGI (Adjusted Gross Income).
Gaining insight into Adjusted Gross Income, its importance, and how it is calculated can pave the way to a prosperous and tax-friendly financial future.
Definition of AGI and its tax implications
Adjusted gross income is calculated by subtracting certain adjustments from your gross income for the year.
Before delving into the calculations, it’s helpful to understand how AGI plays an important role in various aspects of taxes.
Starting point for calculating taxable income
AGI is the starting point for calculating your taxable income and is the number the IRS uses to calculate your taxes. Lowering your AGI reduces your taxable income, leading to a more favorable tax bill. Who wouldn’t be happy about this?
Note: The NewRetirement Planner has several tax tables to help you learn more about your taxable gross income by source (earned income, pension, Social Security) and taxable net income by federal tax bracket.
Eligible for tax deduction
AGI determines eligibility for various tax credits. Tax credits directly reduce the amount of taxes owed. The actual tax amount will be reduced by $1.
To qualify for certain tax credits, your adjusted gross income must not exceed certain limits. This limit varies depending on your filing status (for example, single, married filing jointly, head of household, or married filing separately).
Credits this applies to include:
- Earned Income Tax Credit (EITC): For low to moderate income individuals and families.
- Credit for the elderly or disabled (“elderly tax credit”): Taxpayers age 65 or older or younger than 65, retired due to permanent and total disability, and receive taxable disability income.
Tax credit limitations
Tax credits reduce your taxable income for the year. The several tax credits available are subject to different AGI limits.
- Medical and dental expenses: When you itemize deductions on your tax return, medical and dental expenses that exceed 7.5% of your AGI are deductible. Therefore, the lower your AGI, the easier it is for your medical and dental expenses to clear the 7.5% hurdle to be deductible.
- Donations to public charities: Itemized charitable contributions to public charities that can be deducted in a tax year are limited to a percentage of AGI. For contributions of non-cash assets held for more than one year, the limit is 30% of adjusted gross income. For cash gifts, the deduction limit is 60% of his AGI.
Impact on social security taxation
The IRS uses a formula to determine whether a portion of your Social Security benefits are subject to federal income tax. This formula is often referred to as the “provisional income” formula.
Provisional income is calculated by adding 50% of your AGI, tax-free interest (such as municipal bond interest), and Social Security benefits.
Therefore, as your AGI increases, more of your Social Security income may be taxed.
Understanding the parts of AGI: gross income and deductions above the limit
Now that you understand how AGI affects certain tax opportunities, you may be wondering what exactly your adjusted gross income consists of.
Gross income explanation
It’s important to understand your gross income before calculating your adjusted gross income. Generally, gross income is the starting point on your federal individual income tax return (Form 1040). The IRS broadly defines gross income as all income from any source unless specifically excluded by tax law.
General exclusions from gross income
As a general rule, all income is taxable unless specifically excluded by tax law. These tax-free sources of income are called exclusions. These are exempt from tax and are not included in gross income.
Common types of income excluded from gross income include:
- Salary deferral for most retirement plans, including pre-tax 401(k) contributions
- Child support payments received
- gifts received
- Life insurance death benefit
- Interest received from local bonds
Common sources of gross income
The amount of income remaining after excluding excluded items is the total income. Common sources of gross income include:
- W2 Wage income (income received from an employer) and other earned income such as bonuses and commissions
- Self-employed (“Schedule C”) income
- Social security benefits (up to 85%)
- pension
- Retirement account withdrawal
- Rental income and royalties
- Capital gains, dividends and interest income
Note: NewRetirement Planner allows you to track different sources of gross income, giving you an accurate view of your taxable income for the year.
Calculating gross income: example
To better understand the calculation of gross income, it may be helpful to look at an example.
In 2023, Jane received:
- Salary is $150,000
- Dividend $5,000
- $1,000 of tax-free interest
- $15,000 gift from mother
Total income is based on income from all sources, so her total income in 2023 is $171,000. However, her total income reported on her tax return would be $155,000, the sum of her $150,000 salary and $5,000 in taxable dividend income.
The remaining $1,000 of tax-free interest income and $15,000 of gifts from the mother are excluded from gross income.
Deductions and their impact on AGI
Once you’ve added up your gross income, check your tax deductions for the year.
There are two main categories of deductions for AGI:
- Deductions exceeding the limit: Before arriving at your AGI, first subtract your gross income.These are often called deductions for A.G.I.
- Below the line deduction: Do this after AGI has been calculated.these are called deductions from Your AGI can be either the standard deduction or your total itemized deductions.
- The standard deduction is a fixed amount that a taxpayer can subtract from their AGI.
- Itemizing deductions involves listing the individual expenses you want to deduct on your tax return, such as medical and dental expenses and mortgage interest.
When calculating AGI, you can reduce your gross income by deductions above the limit. Some of the more common deductions include:
- Unpaid expenses for educators working in schools
- Contributions to a Health Savings Account (HSA) (off-payroll)
- Travel costs for military personnel
- The portion eligible for deduction is self-employment tax
- Contributions to self-employed retirement plans such as SEPs and SIMPLE IRAs
- Health insurance premiums for self-employed people
- Qualified Contributions to a Traditional IRA
- student loan interest
arrive at adjusted gross income
Once you know your gross income and deductions above the limit, it may be helpful to look at an example AGI calculation.
Joe and Jane Smith are in their early 60s and file their taxes jointly. Their total income is:
- Joe’s taxable wages from Form W-2: $100,000
- Jane’s taxable wages from Form W-2: $175,000
- Interest income: $10,000
- Dividend income: $6,000
Their total income is $291,000.
Deductions above the limit include:
- Health Savings Account Contributions (made outside of salary): $7,750
- Educator expenses: $300 (Joe is a teacher)
Their total over-the-limit deductions are $8,050.
AGI is calculated as follows:
- Total income: $291,000
- If your deduction is less than the limit: $8,050
- Equals adjusted gross income: $282,950
Check your adjusted gross income on your tax return
Fortunately, if you use a tax professional or tax software to handle your taxes yourself, you don’t have to dig too deep into the details of calculating your adjusted gross income separately.
You can find your adjusted gross income on your tax return on line 11 of Form 1040. The cover page of the 2022 Form 1040 with AGI is shown below.
Knowing your AGI is helpful, but it’s important to have an overall financial plan
Calculating your AGI (or being able to see it on your tax return) is helpful, but having a well-documented overall financial plan is key to your overall financial health.
NewRetirement Planner helps you plan for one of the biggest changes in your life: retirement. It offers user-friendly features and the ability to manipulate numerous variables, allowing you to customize your retirement plan to suit your preferred lifestyle and financial capabilities. You can set different levels of income, different spending levels, understand potential lifetime taxes, and more.
By understanding your AGI and using this planner to plan for your retirement, you can pave the way to a financially prosperous future.