Figuring out your adjusted gross income (AGI) is a key step in calculating your tax liability for a given tax year. There are several common misconceptions when a non-tax-professional is learning how to calculate AGI – we’ll go into detail and soon have you calculating your AGI number like a pro.
The IRS rarely taxes every dollar of income a person makes in a year. They reduce the amount of income taxed based on certain activities. These reductions in taxable income are called “deductions”. The ability to give deductions lets the IRS extend tax advantages to those in poverty, incentivize charitable donations, and empower students and educators financially, among other things. For example, if I make a total of $45,000 per year (my gross income), and I donate $5,000 dollars to charity, the IRS will only tax $40,000. I can take a $5,000 deduction for charitable contributions.
To show this in action, let’s assume the IRS taxes us at 20% (An oversimplification). If we don’t deduct our charitable contribution, they take 20% of 45,000, meaning we owe $9,000 in taxes that year. With the $5,000 deduction, we only owe $8,000, because they would take 20% only from our $40,000 taxable income.
Claiming deductions is an important way to save — sometimes thousands — on your tax bill. This is especially true if you are a business owner, have close ties with charity or education, or pay a lot of interest in a given year.
But what does this have to do with my AGI Number?
Glad you asked! If you’re inferring that deductions are “adjustments” to your gross income, you’re technically right. But only a certain type of deduction factors as you learn how to calculate AGI: above the line deductions. (Above the line deductions are also referred to simply as “adjustments”, but for this article, we’ll compare them and classify them with other deductions.)
There are three general classes of deductions — above the line deductions, itemized deductions, and the standard deduction (the latter two are considered “below the line” deductions). Only above the line deductions matter when calculating your AGI number. You can choose to take itemized deductions or the standard deduction after your adjusted gross income has been calculated. They reduce your taxable income even further, adding to the above the line deductions used to calculate your AGI number.
Above The Line Deductions (Found on the 2019 IRS Schedule 1):
- Educator expenses
- Certain business expenses of reservists, performing artists, and fee-based government officials.
- Health savings account contributions
- Moving expenses for members of the Armed Forces
- A portion of self-employment tax
- Self-Employed SEP, SIMPLE, and qualified plans
- Self-employed health insurance deduction
- Penalty on early withdrawal of savings
- Alimony paid
- IRA contributions
- Interest paid on student loans
- Educational tuition and fees
How to Calculate AGI
Calculating your adjusted gross income is simply taking your gross income, and subtracting your above the line deductions. With a few definitions, it’s not that difficult to understand! Gross Income – Above the Line Deductions = Adjusted Gross Income. Now you know how to calculate AGI from your W2 (The form you’ll find your gross income on) and get ready to claim your below-the-line deductions.
In case you haven’t noticed, AGI is the “line” in “above-the-line” or “below-the-line”. This is where many get confused. They think your adjusted gross income is your taxable income — the number after all deductions have been taken. Adjusted gross income is just an intermediary step!
Why is Adjusted Gross Income Important?
When taking your below-the-line deductions, you can choose to either itemize or take the standard deduction. If you itemize, you have to go through the IRS schedule and total the dollar amount you spent on every area that qualifies as deductible. It can be a time-consuming hassle, and for many people doesn’t amount to much. The standard deduction is a baseline, no-questions-asked dollar amount you can deduct from your adjusted gross income. In 2018 it was increased to $12,200 for individuals, and $24,400 for married filers filing jointly. For many tax filers, this is a great option because it lets them take the $12,000 even if they didn’t donate to charity or participate in education.
The beauty of calculating adjusted gross income before deciding between itemizing or standard deductions is that even if you choose the standard deduction you can still get benefits for participating in education, self-employment, or health savings account contributions. This still incentivizes certain activities, even if the filers are choosing the standard deduction over itemizing.
Beyond tax benefits, your AGI number is used in calculations all throughout tax code and IRS forms. It’s an important figure that speaks quickly about somebody’s tax liability without getting too specific.
Learning how to calculate AGI is an important part of becoming tax-savvy. As with most of the tax code, ensuring you have a good grasp on a few basic definitions goes a long way towards comprehending bigger concepts. Happy filing!