Whenever you fill out your tax return, regardless of whether it's on a Form 1040, 1040A or 1040EZ, the form will always calculate your Adjusted Gross Income (AGI) before arriving at your final taxable income. There are specific components that go into your AGI calculation, and depending on your circumstances, the number may affect your ability to claim deductions and credits.
The first section of all tax returns starts with the reporting of all categories of gross income. Your gross income includes all types of income, regardless of its source, that you receive during the year. Commonly, this includes the salary you earn at work, interest you accrue in bank accounts, your capital gains, alimony payments you receive, rental income, IRA distributions and even a portion of your Social Security benefits in some cases. In order to exclude any of the income you receive it must either specifically be tax-exempt, such as municipal bond interest or be from a gift or inheritance.
Schedule C Income
Although the income you receive from a business you operate as a sole proprietor or for services you provide as an independent contractor is included in gross income, you must separately calculate it on a Schedule C. The Schedule C requires you to report all of these earnings and then reduce it by allowable business expenses you incur. Once you subtract your business expenses to arrive at your net taxable income, you must transfer the amount to the "income" section of your tax return to include it with gross income so that you can accurately calculate your AGI.
Adjustments to Income
The final step, and probably the most vital, in calculating your AGI is to claim all adjustments to income you are eligible for. These adjustments are no different than deductions; however, the difference is that they are available to all taxpayers who qualify, regardless of whether they claim the standard deduction or elect to itemize. Some of the deductions in this category include student loan interest, the tuition deduction, moving expenses, IRA deductions and the alimony you pay to a former spouse. After reducing your gross income by these adjustments, you finally arrive at your AGI.
Significance of AGI
Your AGI is one of the more significant numbers on your tax return because the IRS commonly uses it as the threshold for qualifying to claim many deductions and credits. For example, the American opportunity credit, which covers many of your educational expenses, is only available when your AGI doesn't exceed certain levels. Similarly, when you claim certain miscellaneous expenses in your itemized deductions, such as job-related expenses, the IRS imposes a 2 percent AGI limitation. This limitation only allows you to claim a deduction for the portion of the expenses that exceed 2 percent of your AGI. So the higher your AGI, the harder it is to deduct these items.
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