One of the most difficult things to grasp about taxes for non-tax professionals is the difference between income (aka gross income), adjusted gross income (aka AGI), modified adjusted gross income (or MAGI), and taxable income (the amount that actually determines your marginal tax rate). We all know our gross income is really just a number on paper. No one actually earns the full amount of income they earn (at least no one complies with tax laws in the United States), but understanding how that number translates to the amount of taxes they pay each year is a mystery. that most leave to the tax geeks of the world like me and my fellow CPAs.
Unless the tax code intrigues you, you don’t have to become an expert on how this all fits together, but I think it’s important to have a general understanding of the different terms. Why? Because you’ll be able to make better financial decisions which, ideally, could save you taxes. Here are some key concepts to better understand:
Adjusted gross income or “AGI”
Why this is important:
Your AGI is the basis of several tax thresholds, including:
- Find out if you are eligible for certain tax credits
- Determine if you can claim medical expenses, all of your itemized deductions and / or miscellaneous itemized expenses
Your AGI is also the starting point for most states to determine your income taxes.
How it’s calculated:
To put it simply, this is all of your income from work, investments, retirement accounts, rental property, etc. minus any expenses considered “above the line” such as IRA contributions, student loan interest, and HSA deposits. Here is the complete list of Form 1040 2016:
If you are filling out a Form 1040A or 1040EZ, you will not have all of these deductions available, so if you have any of these deductions, you will want to use Form 1040.
Modified adjusted gross income (“MAGI”)
Why this is important:
Your MAGI adds some of the above-mentioned “above-the-line” deductions and determines things such as your eligibility to: contribute to a Roth IRA, receive a deduction for tuition and fees, receive credit from Medicare tax and deduct contributions to a traditional IRA (when you have an employer-sponsored retirement savings plan, such as a 401 (k), available to you).
Why you should care
Here are some examples of why you should have a rough idea of what your AGI and MAGI are:
- You exclude making Roth IRA contributions because your salary exceeds the income limits, not understanding that the limit is based on your MAGI for IRAs. If you contribute to your 401 (k) at work, deposit funds in your HSA, or even pay child support, your MAGI may fall below the limits and allow you to contribute.
- You have sold a stock that was offered to you many years ago by a relative and the gain from the sale pushes you beyond MAGI limit resulting in a supplement net investment income tax. If you had known this before, you could have taken steps to minimize this additional tax.
- You go to great lengths to document your charitable donationsincluding keeping meticulous records of the merchandise you drop off at thrift store donation centers. This is generally good practice, but if your AGI exceeds certain limits, your itemized deductions (including charitable donations) may be limited, making this effort unnecessary.
- You are retired and decide to make a last minute withdrawal from your IRA just before the end of the year, not realizing that the withdrawal increases your AGI, subduing more of your Social Security Income Tax.
Avoiding these situations requires careful tax planning and expert assistance. But these are just a few of the reasons why we should all try to be a little more educated about how the income tax system works so that we know when to deepen certain financial measures before taking them. After all, who wants to pay more taxes than they need?
Disclaimer: Kelley Long is not a practicing tax practitioner, the contents of this article are for informational purposes only and should not be construed as tax advice, and taxpayers should always consult a tax practitioner for tax services. tax planning and / or tax related matters.