Adjusted Gross Income (AGI)
What it is:
How it works/Example:
AGI is calculated by adding together all qualified income and subtracting all qualified deductions. It is in the taxpayer's best interest to get their adjusted gross income as low as possible. Lower AGI qualifies the taxpayer for more tax benefits and ultimately results in a smaller tax bill.
To calculate your AGI, you must first determine your gross income. This represents the total of all the money you earned during the calendar year. Sources include a person's (or household's) total annual wages, interest, tips, taxable Social Security benefits, income from rental property, dividends, capital gains, royalties, income from retirement accounts, and alimony received. Some income is not included as gross income, such as income on tax exempt local and state bonds.
From this total, deduct items such as contributions to deductible retirement accounts, alimony paid, interest on student loans, certain qualified medical expenses, moving expenses, alimony you pay to others, early withdraw penalties on savings accounts, educator expenses, 50% of the self-employment tax, self-employed health insurance premiums, and qualified tuition and fees paid by students.
Let's look at an example.
Assume Bob and Sally are married and file a joint return. Bob and Sally each earned $90,000 per year, and their investments returned $10,000 in dividends. Bob and Sally's AGI equals $90,000 + $90,000 + $10,000 = $190,000.
Why it matters:
Adjusted gross income often is referred to as " ", because AGI constitutes the net amount of income that is taxed after all tax payments and credits are factored in. It's logical, then, that the very first page of IRS forms 1040 and 1040A are devoted to calculating AGI.
AGI is perhaps one of the most important numbers in a tax return because it determines the taxpayer's eligibility for certain deductions, tax credits and programs. These include a tax deduction on traditional Individual Retirement Account (IRA) contributions and whether you qualify to contribute to a Roth IRA. All of these considerations have limitations predicated on AGI.
Take our hypothetical couple as an example. If Bob and Sally paid a combined $5,000 in student loan interest during the year, they can't deduct it because their AGI is over $140,000. That's why, for the purposes of individual income tax forms, AGI is far more important than gross income.