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Ever wonder what your tax guy means when he talks about your adjusted gross income? Tax talk can be confusing, but it's important to know what this term means and how it affects your finances, especially as tax time approaches.
What Is Adjusted Gross Income?
Simply put, adjusted gross income, or AGI, is the starting number for determining what taxes you might owe, or what you may get back. AGI is calculated by taking the total amount of money you earned in one year and subtracting specific items. Once you have your AGI, you can add in deductions and credits to determine your taxable income and, subsequently, your tax bracket.
To fully understand AGI, let's start with what gross income is and how it's calculated. Your gross income is essentially the total amount of income you receive in one year. That includes wages, self-employed income, tips, investment dividends, taxable interest, taxable alimony, royalties, capital gains, income from real estate investments and other taxable income. There are some exceptions, such as life insurance benefits, some Social Security benefits, scholarships, and certain employee benefits.
How to Calculate Your Adjusted Gross Income
Your AGI is then calculated by subtracting eligible adjustments from your gross income. These deductions include items such as student loan interest and tuition, alimony, retirement account contributions, and educator expenses. These items are also known as above-the-line deductions.
Once you've subtracted your adjustments from your gross income, the number you're left with is your adjusted gross income.
Adjusted Gross Income and Your Taxes
Your AGI has historically been important because it dictated your eligibility for additional deductions when filing your tax return. The deduction eligibility used to depend, in part, on the type of Internal Revenue Service tax form you filled out. But in late 2018, when the new tax law took effect, the new IRS Form 1040 replaced the two existing variations—Form 1040A and Form 1040EZ—changing the guidance for itemized and standard deductions.
According to the IRS, itemized deductions are no longer limited because your AGI is over a given limit. In the past, people with AGIs over a specified amount would be limited to certain deductions. Your AGI may still have implications for your state-level tax returns, however, depending on your state of residence and filing status. Consult with a tax professional or visit the IRS' website to figure out how your AGI might impact your return.
Adjusted Gross Income in Lending Decisions
Adjusted gross income is not only used when filing taxes but also when you are applying for major loans like mortgages. Mortgage lenders want to be sure that potential borrowers can cover the monthly payment, so they use your AGI to get an accurate snapshot of your income.
Your AGI, along with other aspects of your financial profile—like your debt-to-income ratio, credit history, and credit scores—can all be used to approve you for a new loan and establish your loan amount and interest rates.
If you're thinking about getting a loan, it's a good idea to get a free copy of your credit reports and scores so you know what lenders will be looking at when considering your applications. Remember: Checking your own credit will not affect your credit score and you can do it as often as you like.
Knowing your AGI is not only important during tax season, but it can have implications for other aspects of your financial life. When it comes to sensitive calculations like this, it's recommended you seek help from trusted tax and mortgage professionals. For more information about the newest IRS tax policies, visit the IRS website. And to find a trusted tax professional, you can use this IRS resource.
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