With the arrival of a new year, tax season is just around the corner, striking fear into the hearts of millions of Americans as they attempt to get their tax filings in order before the tax deadline arrives. Dramatic, huh?
But honestly, for many people, this can be the most stress-inducing time of the year as their tables become covered with numbered forms like 1040s and 1099s. Thanks to a dizzying array of deductions, credits and exceptions, navigating the tax code, rules and regulations can be very frustrating.
Of course, the terminology of even basic concepts can be difficult to grasp. For instance, consider income, something that most people believe is easy to calculate. However, the Internal Revenue Service has a variety of definitions with respect to income, such gross income, total income, adjusted gross income and modified adjusted gross income. It would be a joke if it were not so serious. And believe it or not, we still didn’t even mention taxable income, the definition actually used to calculate tax!
Thankfully these terms are not as intimidating as they may first appear. Let’s walk through income as it relates to filing your tax return. And for simplicity let’s skip the official IRS definitions of income; I’ll do my best to explain them in regular words!
Definitions of Income for Your Tax Return
- Gross Income: Gross income, is the term most people would associate with income: the total amount of money a person earned in a given year. Among other things, this includes salaries, wages, tips, interest and dividends. Your gross income is the money you earn at your job before all of the deductions on your paycheck. For example, if you work at a job and are offered a $50,000 salary, which is referred to as your gross income.
- Total Income: When you begin filling out your tax return, contrary to popular belief, you do not start with your gross income. In our example, if you have a job where you earn $50,000 gross, but you put $5,000 into your 401k, you’ll actually report only $45,000 of total income for your salary. Luckily, your employer will help you compute this by issuing you a W2 form. Box 1 on your W2 will have the correct amount of total income for your job. In addition, you’ll get 1099s to help you determine the rest of your total income.
- Adjusted Gross Income: However very few people will actually pay taxes based on the amount of total income they have earned. This is because there are a variety of deductions you can take in order to reduce your income. This is just what adjusted gross income (AGI) specifies: the amount of gross income after adjustments. Although this can be a complicated chore, it does reduce your total tax burden. Some adjustments that are normally used to calculate adjusted gross income include business expenses, education costs and IRA contributions. In our example, if you paid $1,000 in student loan interest, your AGI would be $44,000. You can see more adjustments in the AGI adjustment list.
- Modified Adjusted Gross Income: With AGI out of the way, we can now calculate modified adjusted gross income. Modified adjusted gross income (MAGI) is used to determine your eligibility for contributions to tax advantaged accounts, such as IRAs. The contribution limits for Roth IRAs and the deduction for traditional IRAs are both based on MAGI. To calculate your MAGI, you’ll need to add back in various deductions to your AGI including the student loan interest we deducted earlier.
- Taxable Income: Once you determine your gross income, then calculate the total income to be reported for taxes, make adjustments to get your AGI, and finally determine your MAGI to make your retirement contributions, we’ll begin working on taxable income. To get your taxable income, you need to subtract your deductions (standard or itemized) and exemptions from your AGI. Once you know your taxable income, you can use the tax brackets to calculate your tax due. Of course, it won’t be the final amount you’ll pay, as you can still deduct your tax credits.
Hopefully, the definitions of income aren’t as scary as they look! I always think it’s easier to define various terms when we walk through an example to link each definition to the next one.