What is the adjusted gross income? How about modified adjusted gross income?
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An income tax form is like a laundry list – either way you lose your shirt…. Fred Allen
I am sure many people do not know what those income types entail and how to figure it out. Today, we will be discussing the importance and the reason to pay attention to these income types.
Did you know that you cannot deduct your school tuition (up to 4,000 dollars worth of deduction!!) if your MAGI is more than 160,000 dollars for people married and filing jointly? This was for 2017.
Last year, we missed this deduction by 1,000 dollars. It hurts. Here are the details of this deduction.
The maximum dollar amount you can claim for the tuition and fees deduction is $4,000 every year.
The deduction is further limited by the following income ranges based on modified adjusted gross incomes. These are 2019 thresholds:
- $4,000 maximum for income up to $70,000 ($140,000 for joint filers)
- No deduction for income over $85,000 ($170,000 for joint filers)
As you can see above, the benefit started to phase out for us at $140,000 from now on for joint filers.
If we were paying more attention, we could have worked one less shift. We could have contributed more into an account like the dependent care flexible savings account (FSA).
We could have enjoyed a month of daycare with pretax advantage. Hindsight is 20:20
That was when I decided to learn about the different types of income, used by the IRS for taxes.
When I got my first paycheck in Canada and the United States, it looked like mambojumbo. Especially when I saw my paycheck sliced into almost half from the gross income.
You will agreewith me that the way the incomes are calculated does not have to be this complex. Simplicity is not a priority for the IRS.
In this article, you will learn the types of income as reported and used by the IRS. You can avoid the mistake we made.
This is also important for future topics. Consider this the vocabulary of your newly found language which is finance.I will refer to this page when we talk about topics in the future like the traditional IRA, Roth IRA etc.
Without further ado. Let us start with the easiest one.
1. GROSS INCOME
Gross income is all the income a person receives across all sources before any deductions. Your gross income includes all wages, dividends, interests, business income, rental income, alimony and that money your uncle gave you at Christmas.
Yes! Cough that money up. IRS is coming for it! If you are not sure whether to include that income, include it just to be safe.
Who cares about your gross income?
Lenders
Lenders are usually concerned about your gross income. Some lenders will not let you borrow more than a percentage of your gross income.
For example,
According to Investopedia, most mortgage lenders use the 28-36 rule to determine how much to lend you.
The 28-36 rule, also called the housing ratio states that your maximum household expenses must not exceed 28 percent of your gross income.
You can have no more than 36% of total debt services, including housing and other debt such as car loans.
People that don’t understand finance
Gross income easily impresses the babies of finance. Wow! she makes 200,000 dollars! But we all know, it is not about how much you make, it matters more how much you keep.
2. ADJUSTED GROSS INCOME (AGI)
In the United States income tax system, in order to calculate your adjusted gross income, you need to know your gross income and your deductions.
AGI is your gross income minus your specific deductions. These deductions are called, “above the line” deduction.
AGI = (Gross income) – (Above the line deduction).
Listed below are some of the specific above the line deductions.
Contribution to traditional IRA, certain expenses asbooks and supplies incurred by teachers,deductions of life tenants and income beneficiaries of property, retirement plan savings for the self-employed,alimony payments, reforestation expenses (very exciting),interest on student loans etc.
The full list can be found on form 1040 of your income tax
Why you should know your adjusted gross income.
It determines whether you qualify for certain tax credits and deductions
For example, in the year 2018, you can only deduct medical expenses that exceed 7.5% of your AGI. After 2018, the threshold increases to 10% of your AGI.
Suffice to say, to deduct more of your medical and dental expenses, you must find ways to lower your AGI. You must do it the legal way of course.
AGI affects how much state tax you pay
3. MODIFIED ADJUSTED GROSS INCOME (MAGI)
To better calculate your modified adjusted gross income, you will have to know your gross income.
You then need to calculate your adjusted gross income. Modified adjusted gross income (MAGI) is the combination of your household’s adjusted gross income plus any tax-exempt interest income you have.
MAGI = AGI + Tax-exempt interest income
The good news is that for most people, their MAGI = AGI. This is because tax-exempt situations are rare. You know Uncle Sam really don’t want you to have that exception.
According to the IRS, your MAGI is your AGI with the addition of special deductions if it applies to you.
Some of these special deductions include student loan interest, tuition, and fees deduction, IRA contributions, taxable social security payments, etc. Find the full list on the IRS website.
Why you should know about MAGI
If affects your qualification for a premium tax credit.
For example,
Below a certain MAGI, you can get some tax credit on health insurance.
Determines if you can deduct your IRA contributions
For example,
If you are single, your MAGI must be less than 137,000 dollars to contribute to a Roth IRA.
If you are married filing jointly, your MAGI must be less than $203,000 dollars to contribute to a Roth IRA.
It determines whether you can take tuition and fee deduction.
See example in the opening paragraph of how we managed to mess this part up. Don’t lose money for no reason.
It affects your deduction contribution to traditional IRA
While the traditional IRA is not my forte, there are many who benefit from the pretax advantage of the traditional IRA rather than Roth which is post-tax.
4. TAXABLE INCOME
This is the amount of income that is taxable. This is the adjusted gross income minus allowances for personal exemptions and standard deduction or itemized deductions.
You have to choose between itemized deduction and the standard deduction when calculating the income tax.
Taxable income = AGI − Personal Exemptions – (Standard Deduction or Itemized Deductions)
Knowing what you can and cannot claim as taxable income can help you immensely with your taxes.
Why you should know your taxable income
This is what is affected by the tax bracket. Lowering your taxable income lowers your overall taxes.
This is the main idea behind many pretax retirement accounts. By contributing to 401k and 457 for example, you effectively reduce your taxable income. You can learn more about 401k concepts here.
5. NET INCOME
In simple terms, this is the money left after everything has been deducted. This definition is obviously different for individuals and companies.
For an individual, your net income is what is left at the end of your paycheck after tax and deductions have been taken out.
Net income = Gross pay – taxes – deductions
For business, this is calculated by start subtracting the business’s expenses, taxes and operating costs from the Total revenue
Net income = Total revenue – business expense – taxes – operating cost.
Why is knowing your net income important?
This is just for you to cry when you compare the gross with your net and find out your net is only about half of your gross.
Were you confused about these different types of income? Will you like to give some input?
Please comment and share.
Adebayo
Website
I am a pulmonary and critical care doctor by day and personal finance blogger/debt slaying ninja by night.
After paying off close to $300,000 in student loan debt in less than 6 months into my real job, I started on a mission to help others achieve the same. There is no magic to this than to strap up and get it done. Some of the ways we achieved this include side hustle, budgeting, great negotiation skills, and geographical arbitrage.
When I was growing up, common knowledge in Nigeria is that there is one thing you cannot trust anyone else with, and you guessed it – your money.
Being frugal came easily to me based on my background. However, the concept of building wealth did not solidify in my mind until when I finished medical school. I wish I knew what I know now when I was 14. Still, I don’t know enough and I am constantly learning to improve my knowledge.
My goal is to reduce financial illiteracy among young professionals. I am catering to the beginners – babies and toddlers in financial literacy.
