What is Adjusted Gross Income (AGI) and How Does it Affect Your Taxes

We toss different terms around to describe our incomes, one of which is adjusted gross income, but what exactly is adjusted gross income (AGI), and is it an accurate way to describe what we make?

What is Adjusted Gross Income?

In its simplest form, adjusted gross income, or “AGI”, is the broadest measure of income from all sources, but it’s also reduced by certain expenses. (This is where the term “adjusted” figures into AGI.)

Because the income reduced, and because certain income isn’t taxable, it’s not accurate to say that AGI describes total income in any way.

AGI isn’t really a general description of income so much as it’s a term specific to income taxes.

It’s your income as the Internal Revenue Service sees it and wants us to report it.  It is everything that is reported on page one of IRS Form 1040.

But even if it isn’t an objective measure of income, it still has major implications, at least as it relates to income taxes.

AGI summarizes all of your income sources

One of the things AGI does do is to summarize and total all of your taxable income.

This is the highest amount of income that IRS taxes, not your total income.  It includes major sources of income from the following:

• Wages, salaries and tips

  

• Interest and dividends
• Taxable state income tax refunds
• Alimony
• Business income
• Capital gains and losses, as well as other gains and losses
• IRA and pension distributions
• Income from rents, royalties, partnerships, S corporations and trusts
• Farm income
• Unemployment compensation
• Social Security
• Any other form of reportable income

As complete as this list seems, there are income sources that are either excluded or only partially included in the total number.

For example, while you will report tax exempt interest income on your tax return, it won’t be included in your final AGI.

Social Security and pension income are also reported on your tax return, but both may be only partially taxable—or not taxable at all—and will not be included in your final AGI.

If we’re talking “real world income”, AGI is rarely a complete number.

A better description of total income actually is found on the 2011 1040 at Line 22 – “Combine the amounts in the far right column for lines 1 through 21 – This is your total income.”

It’s important to remember however that this is your total income for tax purposes only, and not your absolute total income.

AGI includes “above the line” expenses

AGI includes not only your total taxable income, but also allows you to reduce that income with the use of certain preferential deductions.

The greater the deductions, the lower your taxable income, the lower your tax will be.

Good deal? Absolutely!

Some of the expenses that get deducted as part of AGI include:

• Health savings accounts
• Moving expenses
• The deductible portion of self-employment tax (FICA taxes)
• Self-employed retirement plans
• Self-employed health insurance
• Alimony paid
• Allowable IRA deductions
• Student loan interest

One of the advantages of AGI deductions is that they apply whether or not you itemize your taxes.

We sometimes hear the terms “above the line” or “below the line” when it comes to income tax deductions, and here is where that term comes from.  The “line” in this case, is the AGI total.

Above the line refers to deductions that are part of AGI, or more simply that appear on 1040 Page 1.

Below the line refers to deductions that appear on Schedule A, Itemized Deductions.

The differences between the two deductions are more significant than where they appear on the tax return.

AGI is used as the basis line in many tax calculations

AGI is mostly a tax term, but it’s one that has broad implications—at least within the tax universe.

AGI is used as a base number for other calculations throughout the tax code, but there are two in particular that affect most taxpayers.

The first is as a baseline for itemized deduction reductions on Schedule A of the federal income tax return.

Certain itemized deductions only count when they exceed a certain percentage of AGI.  Medical deductions are one—you can only deduct them to the extent that they exceed 7.5% of AGI.  Another is un-reimbursed employee business expenses and other miscellaneous deductions—they can only be deducted to the extent that they exceed 2% of AGI.

The second major tax category that is affected by AGI is state income tax calculations.

Most states base taxable income on federal AGI, and often federal itemized deductions, but changes occur for those who don’t itemize.  States usually set different allowances for personal exemptions and for standard deductions.  Some have deductions beyond their standard deductions as well.

But it all starts with federal AGI, and works its way down from there.

What is your understanding of AGI? Does this post clear up any misunderstandings you had?