If you prepare your own tax return, or aspire to do so, you will need to understand the concept of adjusted gross income, or AGI. It's important, because many tax rules and privileges are based on your AGI.
You probably have a good idea of what gross income and taxable income refer to, but let's review them also, because your adjusted gross income is related to both of them.
The following two equations summarize how income is treated on your tax return. You start with your total, or gross, income, and after adjustments, you get your adjusted gross income. Next, subtract exemptions and deductions in order to arrive at your taxable income. (This serves as a good reminder that not all of our income is actually taxed.)
Adjusted Gross Income (AGI) = Gross income - Adjustments
Taxable Income = Adjusted Gross Income (AGI) - Exemptions - Deductions
Gross, adjusted, and taxable income
Your gross income reflects all the income you received over the course of a year, before anything is subtracted from it and before it is adjusted in any way. It includes almost all income from a wide variety of sources, such as salary, bonuses, tips, dividends, interest, rental property income, severance pay, alimony payments received, gambling winnings, and so on. Even a canceled debt you once owed is usually considered income to you. There are exceptions, though, such as child support payments, life insurance proceeds, money you borrowed (such as via a car loan or mortgage), qualified scholarships, and gifts and inheritances. (Inherited retirement accounts sometimes do count.)
From your gross income, you make adjustments, subtracting sums such as contributions to qualified retirement accounts, alimony payments you made, qualifying moving expenses, qualified student loan interest paid, half of any self-employment taxes you paid, and any medical savings account deductions. That leaves you with your adjusted gross income, which is used to determine limitations on a number of tax issues, including exemptions, deductible IRA contributions, and itemized deductions.
To arrive at your taxable income, you start with your adjusted gross income and then claim your exemptions and make your deductions -- either taking an itemized deduction or a standard deduction, whichever is greater. Your taxable income, then, is not necessarily your total, or gross, income, as your total income may well include non-taxable money. Even if your only income is a taxable salary, you won't be taxed on all of it. The taxes you ultimately pay each year are based on your taxable income, not your gross income or your AGI.
Adjusted Gross Income (AGI)
Your adjusted gross income is used for many purposes on your tax return, such as helping determine your eligibility to take certain deductions. For example, taxpayers can, in most cases, deduct the value of charitable contributions made, up to 50% of their AGI. When it comes to qualified medical expenses not covered by health insurance, most people can deduct just that portion that exceeds 10% of their adjusted gross income (AGI) (or 7.5% of AGI for those aged 65 and older, through 2016 -- the 10% rule applies to all taxpayers regardless of age beginning January 1, 2017). Thus, if your AGI is $60,000 and you're 50 years old, you can deduct the portion of your qualifying medical expenses that exceed $6,000.
It's worth noting that your adjusted gross income is sometimes modified further in order to determine whether your retirement-plan contributions are deductible, among other things. To calculate it, you start with your AGI and add back deductions. Many people will have no applicable deductions to add back, so their modified adjusted gross income, or MAGI, will be the same as their AGI.
The deductions that are added back include student loan interest, half of any self-employment tax, qualified tuition expenses, any deduction for tuition and fees, any passive loss or passive income, rental losses, IRA contributions, taxable social security payments, and any loss from a publicly traded partnership.
Understanding your adjustable gross income and the role it plays in your taxation can help make your tax-preparation process smoother.
Taxes are important, but so is investing. And a good investor needs a good broker. To that end, visit our broker center to locate the broker that's best for you.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!