Your adjusted gross income is the amount of income for which you’re required to pay taxes. It’s a modification of your gross income, which is the total amount of money you earn in a year.
If you save for retirement in a qualified account, if you’re self-employed, or if you meet a variety of other criteria, you don’t have to pay taxes on your full gross income. Instead, you get to take “above the line” deductions, which means they actually reduce your taxable income. Adjusted gross income (AGI) is the taxable amount you’ve earned during the year.
When you get ready to file your tax return, your AGI is the first item you need to figure out. It’s the starting point for determining your tax bill, including the determining factor for which tax bracket you fit into, and whether you qualify for certain tax deductions and tax credits.
If you file your taxes online, the tax software program you use will probably figure out your AGI for you. But it’s helpful to understand how to calculate AGI, as there may be things you can do to lower it. And a lower AGI means you’ll have a lower tax bill.
Start with your gross income. That includes all your earnings during a particular year from all sources, which may include wages, dividends, alimony, capital gains, taxable interest income, royalties, rental income, and retirement distributions.
Next, you subtract any above-the-line deductions that you qualify for. These deductions, known as adjustments to income, directly reduce your taxable income. Some of the most common ones include:
Half the self-employment tax
Contributions to a health savings account (HSA)
Alimony (deducted by the payer spouse but taxable for the recipient spouse)
Early-withdrawal penalties charged by financial institutions
School tuition, fees and student loan interest (with some exceptions and limits)
Pay for jury duty that was turned over to your employer
Some business-related expenses for teachers, certain government officials, reservists and performing artists.
It’s important to make sure you qualify for any income adjustments you plan to take. You can review the qualifications on the IRS website.
When you subtract the income adjustments for which you qualify from your gross income, the difference is your adjusted gross income. With that figure, you’re ready to determine how much income tax you owe.
Adjusted gross income is reported right on your Form 1040, the U.S. Individual Income Tax Return, when you file federal income taxes. If you qualify for adjustments to your gross income, you’ll have to complete a Schedule 1, which is an attachment to Form 1040.
On Schedule 1, you’ll show any adjustments you’re allowed to make and their amounts. Then you’ll enter that number on your Form 1040, subtract it from your gross income, and enter it as your adjusted gross income. For tax year 2018, the most recent year for which tax forms have been released, AGI was reported on line 7 of Form 1040.
Your AGI matters because it determines your eligibility to claim a variety of deductions and credits that are available. Taxpayers with a lower AGI will be eligible to take a greater number of deductions and credits.
That’s because many deductions are calculated as a percentage of your AGI. For instance, in 2019, the IRS allows all taxpayers to deduct medical expenses that exceed 10 percent of their AGI. So if you report $20,000 in medical expenses and an AGI of $100,000, you’ll only be able to deduct $10,000, as that is the amount above 10 percent of AGI. However, if your AGI is $50,000, you can deduct anything above $5,000—so you are able to deduct $15,000.
There are a number of ways to lower your AGI. First, make sure you’re taking advantage of any above-the-line deductions for which you qualify. That means if you work as an educator or performing artist, or if you’re a reservist, make sure you understand the business expenses you can use to adjust your income, and take advantage of them.
If you have student loans, you can slow down your repayment to decrease your AGI. It’s usually a good idea to pay off your student loans as fast as possible so you can hold on to more of your money for other financial goals. But if you want to lower your AGI, student loan interest is one of the qualified ways to reduce it. When you take your time to pay off your student loans, more of your payment will be interest, and interest on student loans can be deducted above-the-line, reducing your AGI.
Contribute to a traditional IRA, Simple IRA or SEP IRA—or increase your contributions to those accounts. Every dollar you add to one of these IRAs is subtracted directly from your gross income, reducing your tax liability. The same is true for contributions to a health savings account (HSA). If you have an HSA-compatible health insurance plan, you can contribute to the HSA up to $3,500 for individual coverage or $7,000 for a family plan each year. And every penny you contribute lowers your AGI.
Also, if you sell stocks or other investments at a loss, that can reduce your AGI. You’re allowed to claim a net capital loss of up to $3,000 each year.
And if your employer sponsors a pre-tax retirement plan such as a 401(k), you can defer some of your income to that plan and that income won’t even show up on your tax return. The amount of your contribution is pulled out before it even gets to the gross income line, so your AGI is reduced from the beginning.
Understanding adjusted gross income doesn’t just mean you comprehend an important line on your tax return. It also means you can actively work to reduce your AGI, and lower your tax bill in the process.
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