Adjusted Gross Income: Form 1040 Decoded

Last week, we took a look at how Total Income is defined for tax purposes. Today, we go down the 1040 to see what’s next: Adjusted Gross Income.

Adjusted Gross Income

Your Total Income (line 7b) on Form 1040 minus Adjustments to Income = Adjusted Gross Income.

The Adjustments to Income come from line 22 of Schedule 1, which, in turn, comes from lines 10-21, above it.

Adjustments to Income

Let’s go down the list to see some relevant examples of what constitute adjustments to income on Schedule 1:

HSA Deduction

• If you have a High Deductible Health Plan (HDHP) and are eligible to contribute to an HSA, the contribution is deductible to you here on line 12.
• In 2020, an individual is allowed to contribute a maximum of $3,550 and a family is allowed to contribute up to $7,100 for the year.
• You fill up Form 8889 to report contributions to HSA as well as distributions taken from HSA, if any.

Moving Expenses

Moving expenses are no longer deductible except for members of the armed forces.

Self Employment Tax

• Self- employment Tax (SE Tax) consists of Social Security Tax and Medicare Tax.
• SE Tax is also called Federal Insurance Contribution Act (FICA) Tax or Payroll Tax.
• If you are employed, half of this tax payment is paid by your employer. The other half is withheld from your paycheck and paid, on your behalf, by your employer.
• If you are self-employed, you pay both the employer and employee portions of Employment taxes.
• The employer portion- that is, one half- of these taxes is then deductible from your Total Income.
• This deduction reduces your taxable income but does not reduce your net earnings from self-employment.
• They total up to 15.3% of your combined wages, tips and net earnings: 12.4% for Social Security Tax and 2.9% Medicare Tax.
• For 2020, only the first $137,000 of your combined wages and net earnings is subject to Social Security Tax.
• However, all your combined wages and net earnings is subject to the 2.9% Medicare Tax.
• Aside from that, there is a 0.9% Additional Medicare Tax on the same income, above a certain threshold. That threshold, for those married filing jointly, is $250,000.
• You report Self-Employment Taxes on Schedule SE, if your net earnings from self-employment is $400 or more in a year.

Self-Employed SEP, SIMPLE and Qualified Plans

• If you contributed to a SEP or SIMPLE IRA or a qualified retirement plan, such as a 401(k) through your business, that goes on line 15 of Schedule A. And you get to deduct it from your Total Income.

Self-Employed Health Insurance Deduction

• If you are self-employed and pay health insurance premiums for yourself, your spouse, your children aged 26 or less and any other dependents, you may take a deduction for those premiums.
• The deduction goes on line 16 of Schedule A and works to reduce your Adjusted Gross Income.

Penalty on Early Withdrawal of Savings

• If you withdraw from a retirement plan before you are eligible to do so, you are hit with a 10% penalty.
• Uncle Sam then generously lets you deduct that penalty from your income, on line 17 of Schedule A.

Alimony Paid

• If you pay alimony to your ex for a divorce or separation before 2019, that amount is deductible next, on line 18.

Deductible IRA Contributions

• Next up, on Line 19 is the deduction for Traditional IRA contributions.
• Roth IRA contributions are not eligible for a deduction (they are made with post-tax money and are not thereafter taxed at any point, as least as the rules stand currently).
• Whether you can deduct your TIRA depends on both: (1) your Modified AGI and (2) whether your spouse and/or you are covered by a retirement plan at work.

Student Loan Interest, Tuition and Fees

• On the next two lines, you may be able to deduct student loan interest and tuition and fees for higher education for yourself, your spouse or a dependent.
• Both deductions are phased out over a certain income limit.
• For both deductions, you must not file as married filing separately.
• A small amount of college tuition and fees is deductible- up to $4000- depending on your Modified AGI.
• It’s okay if you also have a 529 for college expenses, as long as the deductible expenses are not coming from the 529.
• You cannot also take the Educational Tax Credits if you are claiming the deduction.

Adding it all Up

• On line 22, you add up all your deductions from the above lines 10-21.
• There are also some other esoteric deductions you can “write in” on this line.
• The number from line 22 of Schedule A is then entered into line 8a of Form 1040.
• This is the sum of all the deductions that go into calculating your Adjusted Gross Income (AGI).

“Above the Line” Deductions

• These deductions are called “above the line” deductions; “the line” being AGI.
• Itemized deductions and Qualified Business Income deduction come into play to reduce Taxable Income after AGI. They are therefore known as “below the line” deductions.
• In general, above the line deductions are better than those below the line because (a) you do not have to itemize your deductions to get them and (b) they reduce your AGI. The AGI, in turn, determines many tax benefits you can qualify for.

Modified Adjusted Gross Income

Modified AGI, or MAGI, does not figure anywhere on your tax return, per se. However, the IRS uses this to calculate:

• If you are eligible to contribute to a direct Roth IRA
• If you can make deductible IRA contributions, despite your spouse or you having a retirement plan at work.
• Whether you are eligible for cost-sharing and the Premium Tax Credit to help reduce your costs, if you purchase through the Health Insurance Marketplace.
• Eligibility for income-based Medicaid
• Eligibility for certain educational tax credits

How to calculate MAGI

Take your AGI and add back some of the deductions into it- and you get your Modified AGI.

The following are some of the deductions added back in:

• Deductible IRA contributions
• Deduction for taxable Social Security benefits
• Student loan interest or tuition deduction
• Deductible portion of Self-Employment taxes
• Passive income/loss
• Rental losses

Next week, we will move on to Taxable Income, which is next on Form 1040.

Thanks for reading!