All income starts with gross income, which is the total of all the money you earn in a year. This includes salaries, wages, bonuses, capital gains, and interest income. As we know from our paychecks, it’s not the money we take home and put into our bank accounts. Our gross income is subject to taxes and often other deductions, which reduce gross income to arrive at net income: our take-home pay.
Adjusted gross income (AGI) also begins as gross income, but before taxes are paid, gross income is reduced by certain adjustments allowed by the Internal Revenue Service (IRS). This reduces gross income and therefore the amount of taxes paid.
Key points to remember
- Gross income is the total amount of money an individual earns, including salaries, wages, bonuses, and capital gains.
- Adjusted gross income (AGI) is an individual’s taxable income after taking into account deductions and adjustments.
- For businesses, net income is profit after taking into account all expenses and taxes; also called net profit or after-tax income.
- Net income is used for both businesses and individuals, while AGI only applies to individuals.
- Adjusted gross income is reported and calculated on Internal Revenue Service (IRS) documents Schedule 1 and Schedule A of Form 1040.
Take-home income is your take-home pay; the amount of money that goes into your pocket after paying taxes and any other deductions. Taxes and deductions are taken from your gross income to arrive at net income.
Common taxes that are levied on gross income include federal income tax, state tax, Social Security tax, and Medicare tax . These are the basics that, when deducted from gross income, resulting in net income.
Employees can also choose benefits that would further increase their deductions, thereby reducing the net income they receive. Many of these deductions are pre-tax, meaning they are deducted from your gross income before tax, which reduces your gross income and therefore the taxes you pay. These items can include health and dental insurance, contributions to company retirement plans such as 401(k)s, and flexible spending accounts.
Businesses also have the concept of net income. Their version of gross revenue would be sales or gross revenue. This is the total value of goods and services sold to customers. From there, they also make deductions from gross income to arrive at net income.
These deductions include the cost of goods sold (COGS), operating expenses, interest expenses, and taxes. Subtracting these costs from total revenue provides net income for a business.
For public companies, all of this information is found in the income statement in the company’s financial statements.
Adjusted Gross Income (AGI)
AGI is gross income that is adjusted through allowable deductions that are allowed by the Internal Revenue Service (IRS). These allowable deductions reduce an individual’s gross income, thereby reducing the taxes they must pay.
For example, a person with a gross income of $88,000 would be in the 24% tax bracket. If this figure were reduced as permitted by the IRS, it could result in an adjusted gross income of $84,000. The individual would now be in the 22% tax bracket and would pay 22% tax on $84,000 instead of 24% on $88,000.
AGI is probably the most important number on Form 1040 because it is the reference number used by the IRS to determine how your taxes are handled, how much tax you owe, and your qualifying benefits.
Items that can be deducted from gross income are described as follows:
- Self-employed persons can deduct several expenses, including health insurance premiums and half of the self-employment tax.
- Those who contribute to Individual Retirement Accounts (IRAs) and qualified retirement plans can reduce their gross income by the amount contributed, up to annual limits.
- Reservists, skilled performers, and government employees paid on a fee basis can claim certain business expenses through Form 2106.
- Those who invest in a Health Savings Account (HSA) can deduct this cost.
- Interest on student loans, but not the principal balance tax-deductible.
- Educator fees are deductible up to $250 per year.
Eligible educators can deduct up to $250 of unreimbursed expenses. For the 2020 tax year, this may include costs for COVID-19 protective items purchased since March 12, 2020.4
All of these expenses are standard above-the-line deductions that can take a while to sort through, but it’s worth taking advantage of every tax break you can find.
Deductions below the line, such as charitable donations or medical expenses, may be subtracted from your AGI after it has already been calculated. These deductions are listed in Schedule A and reported on Form 1040.
Medical expenses must exceed 7.5% of the AGI to qualify for the deduction. In addition, deductions for cash contributions to charities are generally limited to 60% of AGI. But in some cases, 20%, 30%, or 50% may apply. These deductions probably determine whether you use the standard deduction or itemize your deductions.
Calculation of Adjusted Gross Income (AGI)
To determine the AGI, start with your gross income, or all the money you have accumulated over the calendar year, and subtract any qualifying adjustments. The IRS allows specific deductions to be taken from your total gross income.
As of January 1, 2019, alimony is no longer an allowable deduction for use in calculating Adjustable Gross Income (AGI).
These deductions are estimated and listed when you file your taxes. Most deductions, or the above deductions, are listed on Schedule 1 and reported on Form 1040. Itemized deductions, which may not apply to every person, are listed on Schedule A and also reported on Form 1040.
Adjusted Gross Income (AGI) is a term used only for individuals and not for businesses. Net income, as mentioned above, is a term used for both individuals and businesses. AGI is only used on individual tax returns.
If you have a sole proprietorship, the profit and loss are completed on Schedule C and attached to Form 1040.