Taxpayers can alleviate the pain of preparing a tax return simply by knowing the Internal Revenue Service (IRS) definition of important terms that have a significant impact on taxable income. Some of the most important accounting terms for taxpayers to know include gross income, adjusted gross income, and adjusted gross income (MAGI).
Gross Income
An individual’s gross income is simply his total income, which is not exempt from tax, during a particular year. Salaries, wages, commissions, and net business income are included in total gross income, and these numbers are used to determine whether an individual should file a return or if an individual can claim the individual as a dependent. If gross income is less than a certain amount, tax filing may not be necessary.
Adjusted Gross Income
An important accounting figure that assists in determining the amount of an individual’s taxable income in a given year is adjusted to gross income. This figure is determined by subtracting adjustments, or above-the-line deductions, from an individual’s gross income. Adjustments may include traditional IRA contributions that qualify for deductions; eligible retirement plan contributions; payment of benefits; and interest paid on student loan balances. For the self-employed, health insurance premiums and half of the personal taxes paid during the year also affect adjusted gross income.
The calculation of adjusted gross income is important for an individual’s tax return because it is used to determine a person’s eligibility to take additional deductions to further reduce taxable income. State and federal tax preparations require adjusted gross income calculations to determine eligibility for further deductions.
Adjusted gross income (AGI) is an Internal Revenue Service figure to determine your income tax liability for the year. It is calculated by subtracting certain adjustments from gross income, such as business expenses, student loan interest payments, and other expenses.
After calculating the AGI, the next step is to subtract the deduction to determine the taxpayer’s taxable income. . In addition, the IRS also uses other income metrics, such as AGI (MAGI) modified for certain programs and retirement accounts.
Key Takeaways
- The Internal Revenue Service uses your adjusted gross income (AGI) to determine the amount of income tax you have to pay for the year.
- AGI is calculated by taking all of your income for the year (your gross income) and subtracting “certain income adjustments.”
- Your AGI can affect the size of your tax deduction as well as your eligibility for certain types of retirement plan contributions, such as a Roth IRA.
- The adjusted gross income is your AGI with some allowable deductions added back. For most people, AGI and MAGI are the same.
- Among the items deducted from your gross income when calculating your AGI are alimony payments and educator expenses.
Modified Adjusted Gross Income
Where most taxpayers are confused in preparing their tax returns is the process of calculating adjusted gross income. This figure differs from adjusted gross income because some adjustments are added back to the total. These adjustments include tuition costs and education deductions, any eligible IRA contributions, losses from rental property, and interest paid on student loans. Self-employed individuals have to add half of the self-employment tax paid as well. MAGI is used to determine whether certain deductions are allowed, including contributions to individual retirement plans.
For most individuals, gross income and adjusted MAGI are similar; however, both must be calculated to determine the amount of taxable income for any given year. Regardless of whether an individual receives a W-2 or is self-employed, understanding the difference between gross income, adjusted gross income, and MAGI is a necessary aspect to file the correct tax return. The majority of tax preparation software programs do these calculations behind the scenes, but individuals can estimate the total amount of tax liability for the year once they understand these income terms.