When your gross income rises, it's a cause for celebration -- and maybe concern. You don't want to lose all that extra money to taxes. That's when adjusted gross income (AGI) becomes important. While your gross income is all of the money you've earned in a year, the AGI is adjusted by subtracting certain allowable deductions.
To calculate your AGI, you first have to identify your gross income by adding up all your earnings. On IRS Form 1040, these are typically your wages, salary, tips, dividends and capital gains, plus taxable IRA distributions, interest, pensions and annuities. Common profits that are also part of your gross income include alimony payments, rental property, business earnings, unemployment payments, royalties and trusts.
Now that you know your income, you adjust it to lower it as much as possible. Common allowable deductions include IRA contributions, interest from student loans, employment-related moving expenses, half of the self-employment tax, self-employed health insurance payments, contributions to certain retirement plans, alimony payments and mortgage interest payments and penalties on early withdrawal of savings. A few deductions, such as tuition and domestic production activities (specific business expenses), require you to submit an additional form with your tax return.
Members of certain professions are entitled to additional deductions. For instance, elementary and secondary teachers can claim some classroom materials they purchased, such as software and books. Reserve members of the armed forces can subtract expenses in relation to their military responsibilities. People in the field of performing arts are also allotted additional reductions. When you've exhausted your supply of deductions, subtract the total amount from your gross income on your 1040, and you have your AGI.
If your state is one that collects income taxes, you'll probably use your federal AGI on your state form. It's to your advantage to thoroughly consider what's counted as income and what's allowed for deductions in order to determine an accurate adjusted gross income. Just like the limbo dance, the key phrase in taxes is, "How low can you go?"