Typically, when a government agency or bank asks about your income, what it really wants to know is your adjusted gross income (AGI). AGI is your total income less certain adjustments.
Adjustments to income can include such items as educator expenses, student loan interest, alimony payments, or retirement account contributions and more. Your AGI will always be equal to or less than your total income.
AGI can be incredibly important at tax time as it can affect the size of certain tax deductions and credits. It can also affect your eligibility to contribute to certain retirement plans (such as your Roth IRA or traditional IRA). Keep reading to learn more about why it's important to know your AGI and how to calculate it.
How To Calculate Your Adjusted Gross Income (AGI)
Adjusted gross income is calculated as follows: Total Income (Gross Income) less “above-the-line” deductions.
Above-the-line deductions are called “above-the-line” because they are on the first page of the 1040 tax form above the line where Adjusted Gross Income is calculated. For everyone who uses tax software, above-the-line deductions aren’t perfectly delineated from standard deductions. The most common above-the-line deductions include:
- Contribution to Traditional IRA
- Certain expenses for books and supplies incurred by teachers
- Interest on student loans
- Higher Education expenses
- Contributions to Health Savings Accounts (HSAs)
- Retirement plan savings for the self-employed
- Self-employed health insurance deduction
- 50% of self-employment tax
- In some cases, Alimony paid (this is for people with divorces before Dec. 31, 2018)
- Charitable contributions up to $300 (In 2020 only)
- Certain expenses of performing artists, state officials, and Army Reserve members
- Moving expenses for Armed Forces members
- Penalties forfeited because of premature withdrawal of funds
Some less common deductions carry-over from the past, but these above-the-line deductions won’t apply to most people.
Focusing on above-the-line deductions is a great way to reduce your overall tax burden. If you’re self-employed (or have a side hustle), you may qualify to contribute pre-tax money to a self-employment retirement plan. People with high deductible health plans may be able to contribute money to an HSA. These actions help you build wealth and cut down on taxes.
Adjusted Gross Income Vs. Taxable Income
Taxable income is the amount of money you have to pay taxes on. This will be your taxable income less either the standard deduction or your itemized deductions. If you own a business, your “Qualified Business Income Deduction” will also be excluded from your taxable income.
Your taxable income drives your tax burden. However, the tax burden isn’t set until after credits (such as the Child Tax Credit, the Dependent Care Credit, Earned Income Tax Credit, and the American Opportunity Credit) is calculated. These directly cut down on your tax burden and drive up your refund.
It's important to note that some states use AGI and some states use federal taxable income for calculating state taxes.
How Does The IRS Use AGI?
The IRS uses AGI to determine what credits and deductions a person is allowed to take. If your AGI is either too high or too low, you won’t qualify for the Earned Income Tax Credit. Your AGI may also lead to phaseouts for the child or dependent tax credit.
Your AGI can also affect whether you’re eligible to take certain income-based itemized deductions. For example, the IRS currently allows all taxpayers to deduct their total qualified un-reimbursed medical care expenses that exceed 7.5% of their adjusted gross income. If you paid $7,000 in medical expenses, and you had an AGI of $40,000, you could claim $4,000 as an itemized deduction.
When combined with mortgage interest and charitable giving, it may make sense to itemize. By contrast, the same person with $140,000 in AGI won’t be able to claim any medical expenses.
AGI also influences whether you can contribute to an IRA. This article explains the exact details of who can contribute to an IRA, and when phaseouts begin.
Do Any Other Government Agencies Use AGI?
Most states that charge income tax rely on the federal AGI to calculate the state income tax that a person owes. Those state agencies may further modify the AGI to either raise or lower tax liability for certain individuals.
Many government agencies use AGI or Modified Adjusted Gross Income to determine a person’s eligibility for benefits. For example, the Department of Education requires all people who want Federal aid to supply their AGI on the Free Application for Federal Student Aid (FAFSA). This one input determines whether you’re eligible for subsidized loans, grants, and other forms of aid.
The Department of Health and Human Services also relies heavily on MAGI (Modified Adjusted Gross Income) to determine eligibility for health insurance subsidies, Medicaid, and CHIP. MAGI is AGI less certain deductions. In the case of DHS, MAGI deducts untaxed foreign income, Supplemental Security Income, and untaxed Interest from AGI.
Careful planning throughout the year can make it easy to lower AGI even if your total income grows. Sometimes, timing major expenses (like a higher education course) can lead to major tax benefits.
But often lowering your AGI will involve contributing more money to tax-advantaged retirement plans or an HSA. Many people prioritize regular savings to these accounts throughout the year. However, you have until the April 15th tax deadline to make your contributions.
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him on the About Page, or on his personal site RobertFarrington.com.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.