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What is Adjusted Gross Income (AGI) & How Does it Work?

April 25, 2022
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min

To determine one’s actual income, the IRS created the AGI, which helps the IRS and taxpayers themselves get a clearer idea of how much money they bring home each year.

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There are two ways to broadly think about a person’s income: the total amount they bring in, and the amount after certain expenses are deducted from that top-line amount. The adjusted gross income (AGI) is one indicator of the latter. 

It’s a figure that gives a better indication of the actual money at one’s disposal in a 12-month period. It’s a starting point used to determine a person’s tax bracket, as well as their eligibility for financial services and products.

What is adjusted gross income (AGI)?

Adjusted gross income, or AGI, is all of a person’s incoming funds, minus certain eligible deductions and credits they must pay, such as student loan interest or self-employment taxes. AGI is a good indicator of how much money one actually has at their disposal, regardless of what their pay stub says.

The total amount of income a person has in a given year is called their gross income. AGI will never be higher than one’s annual gross income. However, AGI can be, and often is, lower than gross income. 

AGI is a useful start to calculate the federal and state taxes one owes in a year. Banks and other lenders may also look at AGI to gauge a person’s financial well-being when they apply for financial products and services. 

If someone applies for a mortgage loan, for instance, their AGI is a better indicator of eligibility than looking at their top-line paycheck. Just because they make $150,000 in a year doesn’t mean that they actually have $150,000 to spend.

How is AGI calculated? 

Adjusted gross income is calculated by adding up all of one’s incoming funds (their gross income), and then subtracting any deductions and expenses for which they are eligible.

Income includes:

  • Salary, wages, and tips
  • Self-employment business income
  • Taxable interest, such as from a savings account
  • Qualified and ordinary dividends
  • IRA distributions
  • Pension and annuity payments
  • Personal items sold for a profit

Deductions, or adjustments, that can be subtracted from gross income include:

  • Student loan interest
  • Self-employed health insurance premiums
  • Self-employment taxes
  • Early withdrawal penalties incurred on savings accounts, such as certificates of deposit (CDs)
  • Moving expenses for eligible armed forces members
  • Classroom expenses for teachers
  • Certain retirement account contributions (such as a SIMPLE IRA, SEP IRA, and qualified plans)
  • Health Savings Account (HSA) contributions 
  • Alimony payments

A person’s AGI for the year is determined by subtracting each of these deductions they qualify for from their gross income. To determine the taxes someone owes, however, there may be more deductions they can take from their AGI.

These additional deductions include charitable contributions, mortgage interest, and the standard deduction. The total income that one is taxed on in a year is their AGI minus these further deductions.

AGI vs. MAGI

The modified adjusted gross income (MAGI) adds back in some of those deductions that were subtracted when calculating AGI. For most taxpayers, the MAGI is one’s AGI before subtracting their student loan interest. 

For many individuals, their MAGI will be very similar to or slightly higher than their AGI. 

The MAGI is often used to determine eligibility for certain tax benefits, like whether an income limitation applies for retirement savings contributions. In other words, if a person’s MAGI is too high, they may not be eligible to deduct their contributions into a tax-advantaged retirement account like a traditional IRA. Or they may be ineligible to contribute to other retirement savings accounts (like a Roth IRA).

The bottom line

A person’s paycheck is a big part of how much money they bring home each year, but it doesn’t tell the whole story. They may also have qualifying expenses that are paid out over the course of the year — such as student loan interest, mortgage interest, and retirement account contributions — that may give a different picture of their financial position.

To determine one’s actual income after these eligible expenses are factored in, the IRS created the adjusted gross income, or AGI. This formula allows for adjustments to income calculations based on certain factors.

AGI helps the IRS, potential creditors, and taxpayers themselves get a clearer idea of how much money they actually had at their disposal in a year.

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