If you've filed your own tax return, you're likely familiar with the term "adjusted gross income," or AGI. Still, other than knowing that your AGI goes on one of the lines in IRS form 1040, few people are aware of what it's used for. With that in mind, below is a guide to this calculation. Keep reading to learn what it is, how it works, and how you can use it to lower your tax bill.
What is AGI?
At its core, your AGI is another name for your tax liability in any given tax year. It is represented by your total annual gross income minus any eligible adjustments as determined by the IRS. It's a measure of how much income tax you owe for the year.
In this case, your gross income is represented as the sum of all the money you earned during the tax year. It can include your business income -- whether salary or wages -- rental income, dividends, each capital gain, each alimony payment, and any retirement distributions.
Once you have that number, you'll have the ability to make certain adjustments to your total income to reduce your tax liability. According to the IRS, the following are considered eligible adjustments to your federal AGI:
- Alimony payments
- Student loan interest
- Educator expenses
- Contributions to a retirement account such as an IRA
Notably, many states will use your federal AGI to calculate how much you owe in state income tax. However, in some cases, this number can be modified by taking state-specific tax deductions or applying a tax credit.
How to calculate your AGI
Now that you understand more about federal AGI and how to use it when completing your tax return, the next step is to learn how to calculate it. To that end, we've broken down the formula for you below:
- Add up your total income: This includes any W-2s, 1099s, and miscellaneous income such as capital gains, unemployment benefits, or retirement distributions.
- Add together any applicable adjustments: Add up any applicable adjustments or "above-the-line" deductions to your income.
- Find your AGI: Subtract the total of your adjustments from your annual gross income to find your AGI.
Calculating federal AGI: A practical example
For the purposes of this example, let's say that you earn $65,000 in salary at your day job and $10,000 worth of rental income from an investment property. However, you paid $3,000 in student loan interest this year and contributed $5,000 to a traditional individual retirement account (IRA).
Your federal AGI calculation would be as follows:
- Find your gross income: $65,000 + $10,000 = $75,000.
- Total your above-the-line deductions: $3,000 + $5,000 = $8,000.
- Calculate your AGI: $75,000 - $8,000 = $67,000 AGI.
While this example worked out fairly neatly, the numbers are rarely so clear when you're filing your tax return. With that in mind, if you have questions about how to calculate your AGI, it's always a good idea to check in with a tax professional.
Comparing AGI and modified AGI
Many people get confused when trying to differentiate between their AGI and their modified AGI, or MAGI. While these numbers end up being closed for most of us, there is an important difference that we should mention.
Your modified AGI is what your AGI becomes once certain tax deductions have been added back in. A tax deduction you take for student loan interest, for example, would be added back into your modified AGI.
These two are used to determine your eligibility for different things. For example, your AGI is used to determine whether you can use the IRS's free-file system to file your annual tax return. Meanwhile, your modified AGI is used to determine your eligibility to get healthcare through the Affordable Care Act.
The Millionacres bottom line
It's important to understand AGI because it determines your eligibility for many tax deductions and credits. Ultimately, AGI is a way to help you lower your tax bill. With that in mind, use this as your guide to this calculation. That said, while this can be a good place to start, if you have more specific questions about your tax situation, it's best to get in touch with a tax professional.