What Is Adjusted Gross Income (AGI) and How Is It Calculated?

Understanding Adjusted Gross Income (AGI) is essential for anyone filing taxes in the U.S. It serves as a starting point for determining taxable income and eligibility for deductions and credits. The IRS uses AGI to assess financial standing, making it a key figure in tax calculations.

Since AGI affects tax liability and eligibility for benefits, understanding its calculation can help with tax planning and financial decisions.

Income Categories in Calculation

AGI is derived from various earnings, including wages, self-employment income, and investment returns. Each category has specific reporting requirements and tax implications.

Wages and Salaries

For most individuals, wages, salaries, bonuses, and tips make up the largest portion of income. Employers report these amounts on Form W-2, and they must be included in total income. Taxable fringe benefits, such as employer-provided group-term life insurance over $50,000, also count toward earnings. Severance pay, stock options, and nonqualified deferred compensation fall under this category.

Pre-tax deductions for benefits like health insurance or flexible spending accounts lower taxable wages but do not directly impact AGI. Understanding how employment income is taxed helps in estimating year-end liabilities and adjusting withholding.

Business Income

For self-employed individuals, gig workers, and small business owners, business revenue is a major part of AGI. This includes earnings from sole proprietorships, partnerships, and certain LLCs, reported on Schedule C or Schedule K-1. Business income is calculated by subtracting ordinary and necessary expenses—such as rent, supplies, and advertising—from gross receipts.

Deductions like depreciation, home office expenses, and vehicle costs can significantly impact taxable income. Net earnings from self-employment also trigger self-employment tax, covering Social Security and Medicare obligations, though half of this tax is deductible. Accurate expense tracking and tax-efficient strategies, such as Section 179 deductions for equipment purchases, can help manage AGI.

Investment Earnings

Investment income includes interest, dividends, capital gains, and rental revenue. Interest from bank accounts, corporate bonds, and Treasury securities is taxable, while municipal bond interest is tax-exempt. Dividends are classified as either qualified or ordinary, with qualified dividends taxed at lower capital gains rates.

Capital gains arise when selling assets like stocks or real estate for a profit. Short-term gains (on assets held for one year or less) are taxed as ordinary income, while long-term gains benefit from lower rates. Rental income is also taxable, but deductions for mortgage interest, property taxes, and maintenance expenses can offset it.

Taxpayers can reduce AGI by managing investments strategically, such as harvesting losses to offset gains or holding assets longer to qualify for lower tax rates.

Adjustments You May Deduct

Certain deductions—known as “adjustments to income” or “above-the-line deductions”—reduce AGI. These adjustments lower taxable income without requiring itemization.

Retirement Contributions

Contributions to specific retirement accounts can lower AGI while providing long-term financial benefits. Traditional IRA contributions may be deductible up to $7,000 in 2024 ($8,000 for those 50 and older), though deductibility phases out at higher income levels if the taxpayer or their spouse has a workplace retirement plan.

Self-employed individuals can contribute to SEP IRAs or SIMPLE IRAs, with SEP IRA contributions capped at 25% of net earnings or $69,000 in 2024, whichever is lower. Contributions to 401(k) or 403(b) plans made through payroll deductions do not directly reduce AGI, as they are excluded from taxable wages upfront. Maximizing deductible retirement contributions can lower tax liability while building savings.

Certain Educational Expenses

Some education-related costs qualify as adjustments to income. The student loan interest deduction allows up to $2,500 in interest payments to be deducted, though eligibility phases out for single filers with modified AGI above $90,000 ($185,000 for joint filers) in 2024.

Educators can deduct up to $300 in unreimbursed classroom expenses, such as books and supplies, with married teachers filing jointly able to claim up to $600. While the tuition and fees deduction was eliminated after 2020, contributions to 529 plans or Coverdell Education Savings Accounts (ESAs) may provide tax benefits at the state level.

Others

Additional adjustments include deductions for health savings account (HSA) contributions, self-employment taxes, and alimony payments under pre-2019 divorce agreements. HSA contributions are deductible up to $4,150 for individuals and $8,300 for families in 2024, with an extra $1,000 allowed for those 55 and older.

Self-employed individuals can deduct 50% of their self-employment tax. Alimony payments remain deductible only for divorce agreements finalized before January 1, 2019, as the Tax Cuts and Jobs Act eliminated this deduction for new agreements. These adjustments provide opportunities to lower taxable income.

Differences from Taxable Income

AGI is an intermediate step in tax calculations but is not the final amount on which income tax is assessed. Taxable income is derived by subtracting either the standard deduction or itemized deductions from AGI.

The standard deduction significantly reduces taxable income. For 2024, it is $14,600 for single filers, $29,200 for married couples filing jointly, and $21,900 for heads of household. Itemized deductions allow taxpayers to claim specific expenses such as mortgage interest, medical costs exceeding 7.5% of AGI, and state and local taxes (capped at $10,000). Choosing between these options depends on which provides the greater reduction in taxable income.

Some forms of income—such as employer-provided health insurance, life insurance death benefits, and certain Social Security benefits—are excluded from taxable income even though they may be reported elsewhere. Tax-exempt interest, such as that from municipal bonds, is not included in taxable income calculations despite affecting other areas of tax reporting.

Role in Determining Eligibility for Credits

AGI determines eligibility for various tax credits, as many phase out or decrease in value as income increases. Since credits directly reduce tax liability, they can provide substantial savings, but only if income remains within qualifying thresholds.

The Earned Income Tax Credit (EITC) benefits low-to-moderate-income workers. For 2024, a single filer with no children must have AGI below $17,640 to qualify, while a married couple with three or more children cannot exceed $63,398.

The Child Tax Credit (CTC) also has AGI limits. The full $2,000 per qualifying child is available to single filers earning up to $200,000 and married couples up to $400,000, after which it phases out by $50 for every $1,000 over the limit.

Education-related credits, such as the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC), are similarly restricted by AGI. The AOTC provides up to $2,500 per student for undergraduate expenses and phases out for single filers earning above $90,000 ($180,000 for joint filers). The LLC, covering tuition and fees for higher education, is reduced once AGI exceeds $80,000 for single filers ($160,000 for joint filers).

Relevance for Financial Planning

AGI influences tax liability, eligibility for government programs, and financial aid. Many financial decisions, such as Roth IRA contributions, healthcare subsidies, and Medicare premiums, are tied to AGI thresholds.

For retirement planning, AGI determines whether contributions to certain accounts are deductible and affects the taxation of Social Security benefits. If AGI exceeds specific limits, up to 85% of Social Security income may become taxable. High AGI levels can also trigger Medicare’s Income-Related Monthly Adjustment Amount (IRMAA), increasing premiums for Parts B and D.

In investment management, AGI impacts capital gains tax rates and the 3.8% Net Investment Income Tax (NIIT), which applies to individuals with AGI above $200,000 ($250,000 for joint filers). Investors can mitigate these taxes by timing asset sales, using tax-efficient funds, or contributing appreciated securities to donor-advised funds. Since AGI also affects financial aid calculations for college students through the Free Application for Federal Student Aid (FAFSA), families with college-bound children may benefit from deferring income or maximizing deductions to improve aid eligibility.