Reported on Form 1040, adjusted gross income is one of the most important figures used in income tax calculations. See our adjusted gross income definition for a closer look at how this figure is calculated and why it’s essential to understand.
What is adjusted gross income (AGI)?
Whether you’re filing income taxes as an individual or as a business, adjusted gross income (AGI) is used as a measure of taxable income. It’s the jumping-off point for calculating income tax liability, along with relevant credits and deductions. When looking at the adjusted gross income definition, it’s a good idea to examine the difference between adjusted gross income vs. gross income.
Adjusted gross income vs. gross income
An individual’s gross income is the total pay received before taxes or other deductions are removed. This includes income received in cash from an employer, but it may also include additional forms of income. Examples include:
Gross annual income is reported each year to the IRS as the total amount of money you’ve earned before taxes, factoring in income from all sources such as those mentioned above.
Businesses sometimes report gross income as their gross profit or gross margin. No matter what you call it, gross income is equivalent to the revenue from all sources, after subtracting the company’s cost of goods sold (COGS).
The difference between adjusted gross income vs. gross income is that AGI is adjusted to account for allowable tax deductions. After these are subtracted from the gross income, the resulting adjusted gross income is used to calculate income tax liability.
Why is adjusted gross income necessary?
Gross income shows all the payments and benefits you’ve received throughout the year, but the adjusted gross income is perhaps more important. Tax deductions used to modify your gross income are considered “above the line,” meaning they’re applied before additional exemptions or itemized deductions. As a result, the AGI is vital to pay attention to because it is used as the starting figure for your tax bill.
This is particularly important at the state level. A number of US states use the adjusted gross income to determine whether state-specific credits or deductions are applicable.
How is adjusted gross income calculated?
The first step in calculating adjusted gross income is to determine your gross income. This refers to all reportable income for the full tax year, including wages, profits, pension payments, Social Security payments, and any other forms of remuneration.
Once you’ve tallied up the gross income, you can subtract relevant deductions and payments to determine your adjusted gross income. Examples of these types of deductions include:
Self-employment tax payments
Student loan interest payments
Retirement plan contributions
Losses from the sale of property
Healthcare savings account deductions
The resulting figure is your AGI. Most accountants, individuals, and businesses will find it easiest to use a tax software program to calculate AGI. This ensures that you don’t miss any potential deductions.
How is AGI used?
After you’ve calculated your AGI, you use this as the starting point for further deductions or credits. Apply standard tax deductions to reach a taxable income or itemize your expenses to take advantage of itemized deductions. The best strategy will depend on your level of income and type of deductions.
Adjusted gross income vs. modified adjusted gross income
Although AGI is an important figure for determining taxable gross income, you might also need to take note of the modified adjusted gross income, or MAGI. This takes the adjusted gross income figure, modifying it by adding certain credits back. Examples could be student loan interest payments or foreign earned income exclusion. The formula for working out MAGI will depend on the type of tax credit and income level.
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