What Is Adjusted Gross Income? Everything You Need To Know. Your adjusted gross income significantly influences your financial life. Read on to learn how to calculate your AGI and how it affects your taxes.
By Dan Bova
Adjusted gross income is a significant number to understand when filing your taxes. It plays a vital role in the amount you owe in taxes and can impact other aspects of your financial life.
This article will explain what adjusted gross income is, how it's calculated and what it means for your situation and goals in a given tax year.
What is adjusted gross income (AGI)?
Adjusted gross income (AGI) is a measure of income used to calculate an individual's federal income taxes. AGI includes all forms of taxable income, such as wages, interest, dividends and capital gains. It also includes specific types of tax deductions like alimony payments and IRA contributions.
AGI doesn't include mortgage interest, charitable donations and some other types of deductions. The Internal Revenue Service (IRS) uses AGI to determine an individual's tax bracket and whether they're eligible for certain tax breaks.
What is modified adjusted income?
Modified Adjusted Gross Income (MAGI) is a critical metric to determine an individual's eligibility for certain tax credits and deductions.
You can calculate it by adding any deductions taken out into your AGI before calculating it, such as student loan interest, foreign earned income exclusion and deductions for traditional IRA contributions.
The resulting amount is then compared to the income thresholds established by certain tax credits and deductions to determine eligibility.
Related: You've Gotten Your College-Bound Student's First Tuition Bill. Have You Made the Right Tax Moves?
How to calculate AGI
The first step to calculating your adjusted gross income is to gather all your relevant income information, including any wages, salaries, tips and other forms of income.
Once you have all this information, you'll need to add it and subtract any deductions you're entitled to. This final number, after calculations, will give you your AGI.
Note that you can take a few different types of deductions when calculating your AGI. The most common is the standard deduction, fixed amount you can deduct from your income.
There are also itemized deductions; these allow you to deduct specific expenses incurred throughout the year. You can take the standard deduction or itemized deductions, but not both.
Once you have your AGI, you can calculate your taxes owed or eligibility for tax refunds. Remember to keep accurate records of your AGI to properly e-file your taxes each year.
The role of AGI in your taxes
AGI is important, but what role does it play in your taxes? Here's what you need to know.
What is AGI on your W-2?
Adjusted gross income on a W-2 form is an individual's total income after certain deductions are removed. This amount can include wages, salaries, tips, commissions and self-employment income as employers report to the IRS on Form W-2.
It also includes taxable social security benefits or pensions, tax-exempt interest income and other items of income (like alimony received).
To calculate your AGI, start with your total income from all sources, then subtract any adjustments to income. Adjustments to income include things like moving expenses and contributions to an IRA.
What can you use AGI for on a W-2?
AGI calculates an individual's total tax liability for the year. It can also be used in determining eligibility for specific deductions or credits.
For example, a taxpayer may need to reach a certain level of AGI before qualifying for the Earned Individual Income Tax Credit. Thus, it's crucial to understand AGI to accurately calculate taxes owed and use the appropriate deductions and credits available.
Here are a few other instances to consider:
- You can use AGI on a W-2 form when applying for financial aid, as most colleges and universities require applicants to provide their AGI from the previous year.
- If you file for bankruptcy, your AGI can be used to determine whether or not you meet the income requirements.
- Lenders typically review applicants' total income to assess their financial risk, so your AGI might be considered when applying for a loan or credit card.
In short, knowing your adjusted gross income on a W-2 form is essential to understanding your taxable income and maximizing tax benefits such as deductions and credits.
It can also be critical when applying for financial aid, filing for bankruptcy or obtaining a loan or credit card. Understanding AGI helps taxpayers better manage their finances and make informed decisions regarding taxes, loans and other financial matters.
Related: The 3 Best Ways To Save on Taxes When You Have Multiple Business Ventures
The role of AGI in your filing status
AGI is a critical factor in determining your financial status. It determines how much money you can save on your taxes, depending on your financial goals.
For many people, their AGI is the same as their gross income. But your AGI will likely be lower than your gross income if you have any deductions, such as for student loan interest or business expenses.
Knowing your AGI also provides a starting point for many other financial calculations.
For example, if you're trying to save for later retirement distributions, you'll need to know your AGI to calculate how much you can contribute to your 401(k) or IRA without exceeding the IRS's contribution limits.
Additionally, your AGI partially determines whether you're eligible for certain tax credits and deductions. You can find your AGI on your most recent tax return if you don't know your AGI.
Once you know your AGI, you can start taking steps to improve your financial status. For example, you can try to reduce the amount of taxable income you earn each year if you want to lower your tax bill.
Or, if you're trying to save for retirement, you can use your AGI as a launchpad to calculate how much money you need to save annually to reach your goal. Knowing and understanding your AGI is a critical first step, regardless of your financial goals.
Related: Individual Retirement Account (IRA) | Entrepreneur Small Business Encyclopedia
AGI vs. salary
The primary difference between AGI and salary is that AGI is what you report to the IRS, while salary is what your employer pays you. AGI includes all of your income, minus certain deductions, while salary is solely your wages or salary. That's why AGI is usually higher than salary.
What impacts a filer's AGI?
The two main factors that can impact your AGI are tax adjustments and income. Generally, the higher your AGI, the more tax you will owe.
Here are five factors that can influence your AGI:
1. Wages and salaries: Wages and salaries are the most common source of income for most households. Your wages and salary from your job are included in your AGI calculation.
2. Business income: If you own a business, you should add any profits from that business to your AGI calculation. This includes any self-employment income, rental income and other revenue streams on your income statement.
3. Investment income: Investment income includes capital gains from stocks, bonds, real estate investments and other investments — all of which are counted as taxable income and included in your AGI calculation.
4. Retirement account withdrawals: Any money you take from a retirement account is considered taxable income and affects your AGI.
5. Social security benefits: Any Social Security benefits you receive are counted as taxable income and added to your AGI calculation.
Remember that not all forms of income are taxed or included in your AGI calculation. Financial gifts and lottery winnings, for example, are not included. And some types of income may be deductible or eligible for other credits that can lower your tax bill.
For instance, you might itemize your deductions. You can also reduce your AGI through credits, such as the child tax credit.
Related: Income Statement | Entrepreneur Small Business Encyclopedia
How to lower your AGI
You have a few options if you want to reduce your AGI on your income tax return.
You could invest in a retirement account to reduce your taxable income and lower your AGI, or you could deduct expenses from your income. This includes things like business expenses or medical expenses. If you itemize your deductions, you can deduct them from your AGI to reduce the taxes you owe (and may even get you a refund).
Here are some other strategies for lowering your AGI:
- Make charitable donations.
- Contribute to a health savings account.
- Invest in an IRA or 401(k).
- Take advantage of tax credits.
- Take the standard deduction.
- Claim dependent care expenses.
Related: 4 Ways Charitable Giving Can Help Reduce Your 2020 Taxes
What does AGI mean for you?
AGI is a substantial number to understand when it comes to taxes. It's used in various calculations and can significantly impact your tax bill.
Fortunately, calculating AGI isn't difficult once you know what goes into the calculation, and knowing how to lower your AGI can save you money on your taxes.
For more information regarding AGI and your taxes, it's best practice to consult with your tax advisor or the Internal Revenue Service (IRS). The IRS website also contains helpful information and guidance for taxpayers.
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