Adjusted Gross Income Defined
Adjusted gross income (AGI) is a taxpayer’s total (or gross) income minus certain “above-the-line” deductions. The IRS uses your AGI as a starting point to determine how much tax you owe.
To calculate your AGI, you tabulate your income from:
- retirement income,
- Social Security benefits,
- capital gains,
- business income, etc.
From that gross total, you then subtract a few adjustments to income (see below.)
The IRS allows you to exclude certain income from your gross total, including:
- Inheritances and gifts
- Life insurance benefits
- Interest income from certain state and local obligations
Of Note: While you may need to report excludable income on your tax return, the IRS does not require that you include it in your taxable income.
“Above the Line Deductions” (a.k.a. adjustments to income)
On IRS form 1040, the agency allows you to adjust your gross income by subtracting certain items to calculate your adjusted gross income. Financial professionals refer to these items as “above the line” because the deductions occur before the line for AGI. The “line” is the number on line 8b of page 1 of your Form 1040. For example, see the image below.
These deductions are useful because they reduce your taxes by reducing your taxable income. As an example, here is a list of typical deductions for the AGI calculation.
Some typical above-the-line deductions:
- Tax-deferred retirement contributions
- Health savings account contributions
- Student loan interest deduction
- Educator expense deduction
- Self-employment tax deductions
- Alimony deduction
- Moving expenses for armed forces
- Expatriate exclusion
Why AGI is Important
AGI is important because the government allows deductions, tax credits, and contributions to retirement accounts and provides benefits from some government programs based on your AGI. For example, Congress recently authorized COVID-19 stimulus checks based on a taxpayer’s AGI.
You will discover that AGI can even have an impact on your financial transactions beyond taxes. As an example, banks, mortgage lenders, and college financial aid programs all routinely ask for your adjusted gross income.
How to Reduce Your AGI before Year-end
Now is a good time to estimate your year-end AGI. You can use the calculator on this website to estimate your AGI. You still have time to make some adjustments before December 31.
Here are some late-year tactics you can take to reduce your AGI.
1. If you have some losses in your taxable security holdings, sell the losing stocks. The losses you incur on the sale will offset any gains in the account.
2. If you have some appreciated stocks, which you want to sell, give them as gifts to a family member. When the recipient is in a lower tax bracket, this tactic can help you reduce taxes you owe on the securities’ gain.
Be aware of the “kiddie tax” if the gift recipient is your dependent child. The kiddie tax is a tax imposed on individuals under 20-years-old whose investment and unearned income is higher than an annual threshold set by the IRS. For 2020 and beyond, the kiddie tax goes back to pre-TCJA rules where the IRS taxes a child’s unearned income at his or her parents’ marginal tax rate.
3. You can also donate any appreciated securities you own instead of cash to IRS-approved charities. In this case, the charity will not owe tax on the gain. Additionally, you can claim the donation at the full fair market value of the donated security. The IRS requires that you own the donated securities for more than one year.
4. Maximize your deductible contributions to tax-favored retirement accounts (IRAs, SEP accounts, 401 (k) accounts, etc.) and health savings accounts. You can visit one of our previous posts to learn more about HSAs here.
5. If you own a small business (or self-employed) and you’re a cash-basis business, you can defer revenue or accelerate expenses. Visit this prior blog post to get more year-end tax tips for small businesses.
AGI vs. MAGI
Don’t confuse adjusted gross income (AGI) with modified adjusted gross income (MAGI.) The IRS calculates AGI and MAGI to determine whether taxpayers may take advantage of certain credits and deductions.
AGI reduces the amount of your taxable income by subtracting certain deductions from your gross income. While MAGI can add back some of those deductions in some cases, for many taxpayers, AGI and MAGI will be the same amount.
The following are some of the deductions taxpayers would add to AGI to calculate their MAGI
- Student loan interest (for taxpayers with income below a threshold)
- One-half of self-employment tax
- Qualified tuition expenses
- Tuition and fees deduction
- Passive loss or passive income
- IRA contributions (for taxpayers with income above a threshold)
- Non-taxable social security payments
- The exclusion for income from exempt state savings bonds
- Foreign earned income exclusion
- Foreign housing exclusion or deduction
- The exclusion under 137 for adoption expenses
- Rental losses (for certain situations)
- Any overall loss from a publicly traded partnership
The IRS uses MAGI to determine if you qualify for certain tax deductions.
If you need help determining your AGI for 2020, please contact us.