The IRS includes a calculation of adjusted gross income (AGI) on every tax return form it publishes. But regardless of whether you file on Form 1040, 1040-A or 1040-EZ, the AGI formula is always the same. Calculating your AGI simply requires you to subtract the deductions that the IRS refers to as “adjustments to income” from your gross income. However, there is more to your AGI than just following the formula.
Gross Income Calculation
The starting point for all AGI calculations is your gross income. Your gross income includes all the money and the value of property you receive during the tax year unless the government specifically exempts it. Typical items included in gross income are your employment and self-employment earnings, the interest you earn in bank accounts, alimony payments you receive pursuant to a divorce or separation agreement and taxable portions of your Social Security benefits. Common sources of earnings that the IRS allows you to exclude from gross income include interest payments from municipal bonds, child support payments, Pell grants and other scholarships for school and the employment income you earn abroad if you’re eligible for the foreign earned income exclusion.
Adjustments to Income
The tax law allows you to directly reduce your gross income with a number of deductions it refers to as adjustments to income. Adjustments are available in addition to your itemized or standard deduction. And although the AGI formula doesn’t change, the types of deductions you can claim each year do. Common adjustments-to-income deductions include your student loan interest payments, half of the Social Security and Medicare taxes you pay on your self-employment income, contributions to traditional IRA accounts and the expenses you incur moving your family and household items to a new location when starting a new job.
Although the federal government doesn’t impose the income tax rates on your AGI, your AGI can affect your ability to claim other tax deductions and credits in other sections of your return. For example, many itemized deductions require your expenses to exceed certain AGI thresholds before you can claim the deduction. This includes your medical expenses, which are only deductible to the extent the total exceeds 7.5 percent of your AGI, job-related expenses that must exceed 2 percent of your AGI and the casualty losses you deduct, which are subject to a reduction that is equal to 10 percent of your AGI.
States Use AGI
Forty-one U.S. states impose some form of income tax on their residents. If you live in one of those states, you must prepare a state income tax return in addition to your federal return when your level of income exceeds your state’s filing threshold. However, most states that impose the income tax use your federal AGI as the starting point for calculating your state taxable income. Therefore, the adjustment-to-income deductions you claim can directly affect your state tax bill, provided your state doesn’t disallow them.