In previous posts of the Personal Finance Basics series, I mentioned the terms Adjusted Gross Income (AGI) and Modified Adjusted Gross Income (MAGI).
It’s now time to explain these terms in a bit more detail as they are key to understanding your income taxes and whether or not you’re eligible for certain tax benefits.
Gross income is your total income.
To calculate your gross income simply sum up all the money you made in the year.
Here are two examples to help clear any doubts.
Say Ms. Frizzle makes:
- $50,000 in salary from her job as a teacher
- $1,250 in interest from her savings account
Ms. Frizzle’s gross income would be $51,250.
Say Wilma makes:
- $25,000 from her job as a reporter for the Daily Granite
- $2,000 from her side hustle as a personal shopper
- $1,000 from walking dinosaurs
Wilma’s gross income would be $28,000.
Adjusted Gross Income (commonly referred to as AGI) is gross income minus some deductions.
These deductions are also called “adjustments”—we are “adjusting” our gross income, hence the name.
This means that AGI will be lower than or equal to gross income.
What are the deductions that we can subtract from our gross income?
- Contributions to a 401k
- Contributions to a traditional IRA
- Contributions to a Health Savings Account
- Health insurance premiums, i.e. what you pay for health insurance every month
- If you’re a teacher, you can use the Educator Expense Deduction, worth $250, for any classroom materials you paid for out of your own pocket
- Up to $2,500 worth of student loan interest
These are the main deductions, though there are a few others, such as alimony payments and moving expenses for members of the armed force.
Let’s calculate the AGI for Ms. Frizzle and Wilma.
Say Ms. Frizzle:
- Contributes $3,000 to her 401k
- Contributes $6,000 to her IRA
- Contributes $1,000 to her HSA
- Pays $50 a month for health insurance, which comes out to $600 for the year
- Spends $400 buying notebooks, tissues, and other materials for her class
Ms. Frizzle’s Adjusted Gross Income would be $40,400.
This is her gross income of $51,250 minus $3,000 from her 401k minus $6,000 from her IRA minus $1,000 from her HSA minus $600 from the health insurance premiums minus $250 from the Educator Expense Deduction.
The Educator Expense Deduction has a maximum of $250. So while Ms. Frizzle spent $400 on classroom materials, she's only allowed to deduct $250.
- Contributed $3,000 to her IRA
- Pays $100 a month for health insurance, which comes out to $1,200 for the year
- Paid $3,250 in interest on her student loans
Wilma’s Adjusted Gross Income would be $21,300.
This is her gross income of $28,000 minus $3,000 from her IRA minus $1,200 from the health insurance premiums minus $2,500 from the student loan interest.
The maximum that can be deducted for student loan interest is $2,500. So while Wilma spent $3,250 on interest, she's only allowed to deduct $2,500.
Modified Adjusted Gross Income (commonly referred to as MAGI) is AGI with some of the deductions we took added back in.
We are “modifying” our AGI, hence the name.
This means that MAGI will be higher than or equal to AGI.
Which deductions are added back to AGI to get MAGI?
- Contributions to a traditional IRA
- Student loan interest
These are the main deductions added back in, though there are a few others.
Modified Adjusted Gross Income is important because it determines your eligibility for certain tax benefits:
- A contribution to a traditional IRA can only be deducted if your MAGI falls under the limit defined by the IRS.
- Student loan interest can only be deducted if your MAGI falls under $85,000 if you’re single or $170,00 if you’re married.
Let’s calculate the MAGI for Ms. Frizzle and Wilma.
To Ms. Frizzle’s AGI of $40,400, we add back her $6,000 contribution to her IRA.
Ms. Frizzle’s MAGI is $46,400.
To Wilma’s AGI of $21,300, we add back her $3,000 contribution to her IRA and her $2,500 deduction for student loan interest.
Wilma’s MAGI is $26,800.
There you have it. You can now confidently explain what AGI and MAGI are to any willing listener—good luck finding one. 🙉
As a quick summary:
- Adjusted Gross Income (AGI) is important because it’s the number you’ll pay income taxes on (after subtracting the standard deduction.)
- Gross Income - Deductions = AGI
- Modified Adjusted Gross Income (MAGI) is important because it determines whether you’re eligible for certain tax benefits, such as the IRA and student loan interest deductions.
- AGI + some deductions = MAGI
Become comfortable with these terms because they’re key to understanding your taxes and your eligibility for the valuable tax-reducing accounts (e.g., 401k, IRA, HSA) at your disposal.
I hope this was helpful. Send me an email if you have any questions.
And if you’re looking to learn more, you can find the whole Personal Finance Basics Series here.
If you prefer watching to reading, here’s an easy-to-follow video I made with all this info:
And here are the slides I used for the video.