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INCOME SHOULD BE ONE of the simplest concepts in financial planning—and yet it turns out to be one of the most confusing, thanks to the multiple ways it’s calculated depending upon whether it applies to income taxes, Social Security and so on. My goal today: Help you sort out income’s shifting definition across the U.S. tax code.
Gross income. This is the granddaddy—income from all sources, before almost any taxes or deductions. For an individual, this includes wages and salary, pensions, interest, dividends, tips, capital gains, alimony and rental income. It can also include up to 85% of a retiree’s Social Security benefits, as we’ll see later.
Adjusted gross income. Commonly called AGI, this is gross income minus certain adjustments, such as up to $300 in educator expenses for teachers, student loan interest, alimony payments and contributions to retirement accounts. AGI determines eligibility for some tax deductions and credits.
Modified adjusted gross income. MAGI is widely used to determine tax eligibility for such things as IRA contributions and the child tax credit, to name just two. For many folks, AGI and MAGI are almost identical because their adjustments to income are little to none.
Unfortunately, the IRS calculates MAGI in multiple ways depending on the deduction or credit in question. Here are some of the most widely used formulas:
Taxable income. This is the bottom line number you plug into the income tax table to see how much you owe Uncle Sam. It’s AGI minus any allowable tax deductions.
For most paycheck workers, their income number is provided on the W-2 form their employer sends after year-end. If you’re self-employed, keeping track of your income and deductible expenses is much more complicated. The IRS provides these guidelines for what is and isn’t considered taxable income, but it doesn’t make for easy reading.
Meanwhile, taxpayers can take one of two paths to determine their tax deductions. They can either claim the standard deduction—$13,850 for single tax filers in 2023 and $27,700 for couples filing jointly—or itemize their specific deductions. Itemized deductions include the basics like mortgage interest paid, charitable deductions, and state and local taxes, as well as more esoteric expenses.
Social Security. This is another whole can of worms. During our working years, there’s a couple of taxable income figures worth knowing. The maximum taxable earnings amount on which you pay payroll taxes is $160,200 in 2023. Once you surpass this amount, you no longer owe the 6.2% Social Security tax. You’re still on the hook for the 1.45% Medicare tax, however, since it has no upper limit.
If you collect Social Security benefits before full retirement age and continue to work for pay, your benefits can be reduced based on your income. If you’re younger than your full retirement age for the entire year, Social Security will deduct $1 in benefits for every $2 you earn above $21,240 in 2023.
In the year you reach your full retirement age, Social Security will deduct $1 in benefits for every $3 of earnings above $56,520 in 2023 until the month that you reach your full retirement age. After that, you can earn any amount with no reduction in benefits.
But hold on, we’re not quite done with Social Security. A portion of your benefit payments may be taxed based on yet another definition of income. This one is called combined income, and it’s your adjusted gross income plus any nontaxable interest income and one-half of the Social Security benefits you receive.
Taxes on benefits begin for single taxpayers with $25,000 or more in combined income, and for married taxpayers with $32,000 or more in combined income. Initially, only 50% of benefits are taxable. But if your combined income rises above $34,000 for singles and $44,000 for married couples, up to 85% of benefits are taxable.
Got all that? Yet even this isn’t a complete list of income classifications, especially for those with complex financial situations. Indeed, there are nuances and subtleties to many of these items. You know the phrase “buyer beware”? The same applies to taxpayers.
Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.
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The IRS uses the term “adjusted gross income” on the 1040 but not simply “gross income”. Instead, they use “total income”. One additional thing that it doesn’t include is contributions to traditional IRAs, 401(k)s, and 403(b)s, which aren’t included in your wages on the W-2.
FYI Alimony is not deductible for divorce decrees after 2018.
Bill W.
I think you referenced this in one of the paragraphs, but I was painfully reminded about it yesterday while doing our 2022 tax return on TurboTax. It is called ‘earned income’.
My wife and I were never able to get a deduction for contributions to our IRA while we were working because we made too much money. We are now retired and only receiving income from pensions, so we have zero ‘earned income’, even though we pay taxes on the pensions. I decided last year to contribute $7000 to my Roth IRA from my taxable brokerage account.
Not so fast – this is not allowed because we have no earned income. Now I have to reverse out the contribution to avoid a 6% IRS penalty that would go on for perpetuity. Ugh.
Thanks Rick. A good and timely topic.
Having previously been a CPA in public practice that focused on preparing individual returns. I would suggest the following when working with a tax preparer –
Complete your tax organizer particularly the questions. If you are unsure of the answer put a “?” on the response and discuss the organizer items with your preparer on the front end. Typically a “yes” response by you means a matter to discuss. No organizer? Ask for one.Gather all tax documents and send / deliver at one time if possible. Many preparers prefer copies vs. original – ask your preparer. If you are sending the preparer paper copies of the documents let them know if the documents do not have to be returned. If your firm uses a secure electronic portal use it to save the preparer time and you money. Most firms now keep all documents in electronic format. You keeping the original, or copies, before sending means the data can be replaced easily if lost in mail, file is corrupted or your preparer drops over in the middle of tax season.There are thieves that want your personal tax data to rob you and/or the government. Do not help them steal your data by sending sensitive tax data in an email or attachment.Let your preparer know about your expectations of the next year estimated income and expected income and life changes (Job change, retirement, illness, marital status, children, college, etc.). The typical SALY default assumption in tax planning for next year, same as last year, may not be to your benefit.Ask what you can do for the current year and future years to make your return filing work easier for both of you and ask your preparer of any ideas on actions you can consider or take to save taxes and time. Ask every year.If you know you are going to be waiting on a K-1 or other documents to file your return in April go ahead and direct your preparer to get the extension now and do the work after April. Most high end tax software programs have a projection feature and if you are using the same preparer as the previous year this tool can be a very efficient way of getting a good guess on your current year tax obligation and actions you may need to take. No one likes being told they need to make a big tax payment tomorrow.If your return is being prepared at a larger firm it may be (think likely) that the person preparing your return is not the person signing it. Tell your preparer you are happy to hear directly from the persons who are doing the hands on work if they have data needs or other questions. Doing so is usually more efficient and may reduce rework time that you are paying for. Partner billing rates are higher than staff.Planning complex tax strategies is usually best on a team basis. Get open communications established between your preparer, financial planner, insurance agent, banker, attorney, etc. as appropriate. If married, having both spouses involved in tax planning usually works best, particularity in the fourth quarter of life. If the future strategies planned events will occur when you or your spouse will no longer be involved evaluate the need and benefit of getting your adult kids (or other beneficiaries) involved now.Check annually that your primary and contingent beneficiaries are as you intend and your will and estate documents are current. If not update them.Best, Bill