When tax time rolls around, many people will start to learn a new vocabulary that includes words they may have never used before. They’ll start worrying about their deductions, exemptions and adjusted gross income. It’s that last term that can be the biggest concern for lawyers, accountants and clients alike. Just what is adjusted gross income? In the simplest terms, adjusted gross income is one’s total gross income derived from any source minus specific deductions that have been outlined in the tax code. Adjusted gross income is a starting point. From there, people can calculate their taxable income by taking their adjusted gross income and subtracting all known exemptions and the standard deduction. To understand more, one must dive deeper into this issue.
Understanding adjusted gross income with an example
The first thing to know when considering adjusted gross income is the meaning of the term “gross income.” The tax code defines gross income as all income derived from any source. For most people, this means their salary, bonuses, rent, pensions, an annuity, any income derived from the ownership of a business and even money they get from a tax refund. It is meant to be a kitchen sink term, so to speak. If you happened to receive money during the year from any source, then that money should be counted and listed as a part of gross income.
Imagine, for instance, that one was working as a lawyer making $100,000 per year. That person worked very hard and earned a $50,000 bonus for bringing new business to the firm. In addition to that, he owns a frozen yogurt business on the side, where he brought in $30,000 in profit during the year. Finally, he received $20,000 in alimony from a rich wife who divorced him to move to Mali earlier this year. To top it all off, he has been a very smart investor, earning $100,000 in dividends during the year. This all adds up to $300,000, which would be his gross income for the year.
To understand adjusted gross income, one must account for all of the adjustments that a person might have. In many cases, what separates a good accountant from a bad one is the ability to identify areas where a person can take those deductions from their gross income. The tax code outlines specific categories, and some of the most popular include costs of doing business for a person who is not an employee, moving costs, any alimony that has been paid out, contributions to health savings accounts or acceptable retirement accounts and even the tuition paid for college.
Looking at the current example, the lawyer spent $20,000 running his yogurt business, he paid $2,000 to move to his current city after his divorce and he had to pay $3,000 in alimony to his first wife, who he actually divorced. He paid $5,000 in school tuition, too. Because he’s smart, he made $5,000 in contributions to a 401(k) retirement account. In total, he has $35,000 in specific deductions. This means that his adjusted gross income is $265,000. From there, his accountants would work to reduce his tax liability even more through additional deductions and exemptions, but the adjusted gross income is the starting point for that activity.