Contributed by: Robert Ingram, CFP®
Tax Filing season is officially underway for the 2022 tax year returns. If you find yourself feeling a little extra stress or anxiety during this time, you are not alone. The U.S. tax code is undoubtedly complicated (that may be the understatement of the year), and your main focus is simply trying to get to the bottom line: how much do I owe, or how much am I getting back as a refund? Sound familiar?
As you are completing and reviewing your tax return, some other line items on your return (in addition to the bottom line) are worth looking at a bit more closely. In particular, your Adjusted Gross Income (AGI) may seem like just a number on the way to calculating your taxable income, which then determines your tax bill. And while that is true, your AGI is also used to determine eligibility for a number of different tax deductions, tax credits, and even retirement plans. It is also used to determine things like Medicare premiums, the amount of taxable Social Security benefits, and whether you may be subject to an additional tax on investment income.
What is Adjusted Gross Income?
Simply stated, your Adjusted Gross Income is your total income minus certain types of…well, adjustments.
This total income would be your gross income that combines a wide range of items, including things like W2 wage income and certain types of employer benefits, business income, Social Security benefits, pension and retirement plan distributions, investment income, capital gains, and other applicable income.
Once your Total Income is determined you would still make other potential adjustments for items that can include self-employment SEP IRA, SIMPLE IRA, or other qualified plan contributions, eligible Traditional IRA contributions, Health Savings Account contributions, eligible student loan interest, self-employed health insurance, alimony paid, and other adjustments.
Why Adjusted Gross Income (AGI) Matters
As mentioned, the AGI is a number on the way to determining your Taxable Income. Potential deductions such as the standard deduction or the itemized deductions, for example, are applied to the Adjusted Gross Income amount.
The applicable tax rates are applied to the Taxable Income to determine your Tax amount (almost), after factoring in additional deductions and/or credits you may be eligible to include.
The result after subtracting and adding any of those items is the amount of your Total Tax.
(A key point to remember here is that while tax deductions lower your income used to calculate your tax amount, tax credits reduce the actual tax amount itself dollar for dollar.)
Based on your total amount of tax withholding and tax payments you’ve made, plus any additional eligible tax credits (e.g. Additional child tax credit, American Opportunity credit, Earned income credit), you may have paid more than the calculated Total Tax amount or less than the Total Tax amount. If you have overpaid, then you would expect a refund. If you have paid less than the Total Tax, then you would owe additional tax.
AGI Determines Eligibility for Some Tax Deductions and Credits
Several tax deductions and tax credits you may be able to take advantage of are subject to different AGI limitations.
If you itemize deductions, medical expenses above 7.5% of your AGI are deductible. Therefore, the lower your AGI, the easier it is for more of your medical expenses to clear that 7.5% hurdle to be deductible.
Itemized charitable donations you can deduct in a tax year are capped at a percentage of AGI. For example, you can deduct cash gifts made to qualified public charities up to 60% of your AGI. Non-cash gifts to public charities, such as stocks, bonds, and mutual funds owned for more than one year, are up to 30% of AGI.
If you have a year with large charitable gifts, in some cases it could actually benefit you to have a higher AGI so that the deductible ceiling is a larger dollar amount. Now, any portion of charitable gifts exceeding the percentage of AGI limit is therefore not deductible for that tax year, but the potential tax benefit is not completely lost.
The amount in excess of the AGI limit can carry forward for use in future tax years (for up to 5 years). But remember, you would still need to itemize your deductions to take advantage of the amount carried over into those years. This is something to factor in to your charitable giving and tax planning, particularly if you expect to take only the standard deduction in the future.
Part of the eligibility criteria for some tax credits is that Adjusted Gross Income cannot exceed certain amounts, depending on your filing status (i.e., single, married filing jointly, head of household, married filing separately). Some credits where this applies include:
Elderly and Disabled Senior tax credit
Modified Adjusted Gross Income (MAGI)
Along with Adjusted Gross Income (AGI), another related term to get to know is your Modified Adjusted Gross Income (a.k.a. MAGI). Your MAGI is essentially your AGI with certain income and deductions added back into that figure. The IRS uses MAGI to determine if you qualify for a range of tax benefits and programs, separate from the deductions and credits using AGI mentioned earlier.
For example, MAGI is used as a criteria to determine
If Traditional IRA contributions are deductible
If you are eligible to contribute to a Roth IRA
If you are eligible for the Child Tax Credit
If you qualify for the American Opportunity or Lifetime Learning education tax credits
If you are eligible for Premium Tax Credits and savings applied to marketplace health insurance plans under the Affordable Care Act
If you pay higher Medicare premiums due to having income above certain thresholds
What makes the MAGI complicated (and often confusing) is that it is not a separate line item shown on Form 1040 of the tax return. Instead, it is calculated and used where applicable when completing your tax return or by external programs using tax return information. Also, the specific calculation for MAGI can be different, depending on how it is used. Different eligibility items add back different deductions or types of exempt incomes in each of their definitions of MAGI. To illustrate this point, let’s look at a couple of specific examples.
In the case of determining if contributions to a Traditional IRA are deductible, MAGI is calculated by adding AGI plus the following items (as applicable):
student loan interest deduction
foreign earned income and housing exclusions
foreign housing deduction,
excluded savings bond interest used for higher education,
excluded employer adoption benefits
On the other hand, for the purpose of determining any Medicare premium adjustments, the Social Security Administration uses MAGI calculated as AGI plus any tax-exempt interest earned.
When determining your eligibility for these types of tax benefits or projecting your Medicare premium, it is important to know the Modified Adjusted Gross Income that applies to each one. For many people without a lot of the unique deductions or exempt income to add back, their MAGI will be very close to their AGI. However, being aware of both AGI and MAGI and how each is applicable can be very beneficial when doing proactive tax planning throughout the year, not only during tax filing season.
The tax code is complex, and determining how tax-related items apply to your unique situation depends on many factors. These are important conversations to have with your financial planner and tax professional, so please don’t hesitate to reach out to us if you have questions.
Robert Ingram, CFP®, is a CERTIFIED FINANCIAL PLANNER™ professional at Center for Financial Planning, Inc.® With more than 15 years of industry experience, he is a trusted source for local media outlets and frequent contributor to The Center’s “Money Centered” blog.
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of the author and not necessarily those of Raymond James. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. Examples used are for illustrative purposes only.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.