The gross income of a person is the sum of all income except income that are excluded from paying taxes. Examples of these exceptions are contributions to a 401k or IRA account, life insurance benefits, and, in certain cases, Social Security.
Once the person has calculated their gross income, there is certain income that they can subtract from this figure. For example, business deductions and some expenses for military reservists and school teachers.
The result after subtraction is called adjusted gross income (AGI).
Article 62 of the Tax Code of the United States (in English) contains the formula to get from gross income to adjusted gross income.
Gross income and adjusted gross income
Why does the Internal Revenue Service (IRS) distinguish between gross income and adjusted gross income? The answer is complicated, like everything to do with taxes. In simple terms, your adjusted income amount on your federal tax return will determine whether you are eligible for certain federal aid programs.
The government believes that if a person receives certain types of income, they should not be excluded from federal aid. Thus, this calculation allows people to discount those types of income so that they can qualify for federal benefits, if their adjusted gross income falls within the range required by the various aid programs.
Standard and itemized deductions
Many times, people confuse standard and itemized deductions with deductions made to arrive at adjusted gross income, but they are different.
- Standard and itemized deductions apply to everyone. Deductions to arrive at adjusted gross income only apply in specific circumstances. For those who do not qualify, gross income and adjusted gross income will have the same amount.
- Standard and itemized deductions are made after reaching adjusted gross income.
Once deductions are made to arrive at adjusted gross income and itemized and standard deductions, then taxable income is arrived at. Only when this number is reached on your 1040 form will you be able to calculate how much you owe in taxes.
Adjusted gross income example
A concrete example can help you better understand these concepts. Suppose a person earns $ 50,000 as an elementary school teacher.
- Gross income: Contributions to retirement and Social Security accounts must be deducted. Assuming those contributions are $ 7,000, gross income is $ 43,000.
- Adjusted Gross Income: This teacher has $ 600 in expenses that qualify for the discount. Your adjusted income will be $ 42,400.
- Taxable income: This teacher has the option of taking the standard deduction, which is $ 12,400 for single people in 2020, or itemized deductions, which have a more complex calculation and only apply in a minority of cases. The taxable income of this teacher is $ 30,000. That is, the tax calculation will only consider this amount.
This means that this teacher has $ 20,000 of income that is not taxed. In addition, when it comes time to see if you qualify for federal aid programs, your adjusted gross income will be looked at, which is $ 42,400. Thus, you will have a better chance of qualifying for these programs than if you counted the $ 50,000 that has as salary.
While the calculations are complicated, each state has many places that provide free tax preparation help. And you can also turn to an experienced tax attorney for advice.
The idea behind all these calculations is to provide discounts to the amount of money that you will have to pay, and thus be able to access certain economic aid that the federal government grants.