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Net Income vs. Adjusted Gross Income: An Overview
Understanding the difference between net income and adjusted gross income (AGI) can be crucial for managing your finances, whether you’re preparing taxes, evaluating your take-home pay, or analyzing a business’s profitability. Both terms relate to income, but they differ in significant ways, especially when it comes to taxes.
All income starts with gross income, which is the total of all the money you make in a year. This includes salaries, wages, bonuses, capital gains, and interest income.
But this differs from the money we take home and put into our bank accounts. Our gross income is subject to taxes and often other deductions that reduce it to arrive at net income, which is also known as our take-home pay.
Adjusted gross income (AGI) also starts out as gross income. However, gross income is reduced by certain adjustments allowed by the Internal Revenue Service (IRS) and is tallied before any taxes are calculated and paid.
One such adjustment is contributions to traditional 401(k) retirement accounts. These contributions reduce taxable income and, therefore, the amount of taxes owed.
Key Takeaways
- Gross income is the entire amount of money an individual earns, including wages, salaries, bonuses, and capital gains.
- Adjusted gross income (AGI) is your income after specific deductions the IRS allows but before taxes are applied.
- AGI plays a pivotal role in determining your tax liability and eligibility for credits or deductions.
- Net income applies to both individuals and businesses, while AGI is used exclusively by individuals for tax purposes.
- Net income for companies is the profit after accounting for all expenses and taxes. It’s also referred to as net profit or after-tax income.
What Is Net Income?
Net income is the amount of money you take home after all deductions have been made from your gross income. This is the amount that ends up in your bank account or paycheck.
Common deductions from your gross income that affect your net income include:
These deductions reduce your gross income and, in turn, lower the taxes withheld from your paycheck. The resulting amount is your net income, or take-home pay.
Net Income for Businesses
For businesses, net income is the profit after all expenses have been subtracted from gross revenue. It’s also referred to as net profit or after-tax income and is reported on their financial statements.
As with an individual’s net income, a company’s net income is determined by applying certain deductions to its gross earnings (gross sales or revenue).
Key expenses that reduce a business’s gross income to net income include:
What Is Adjusted Gross Income?
Adjusted gross income (AGI) is calculated by taking your gross income and subtracting certain allowable deductions or adjustments. The IRS defines these deductions and can reduce an individual’s gross income, thus reducing the taxes they will owe.
Common AGI deductions include:
- Contributions to retirement accounts (e.g., 401(k), IRA)
- Health insurance premiums for self-employed individuals
- Student loan interest
- Alimony payments (for divorces finalized before 2019)
- Health Savings Account (HSA) contributions.
Adjusted gross income is used to determine your tax bracket, ultimately determining how much you owe. Each year, the IRS adjusts the thresholds for each tax bracket to account for inflation..
How AGI Affects Your Taxes
AGI is a critical starting point when filing your taxes on Form 1040. It determines:
- Your taxable income: Income after deductions but before applying tax rates).
- The tax bracket in which your income falls: The IRS uses your AGI to determine your taxable income, which is then taxed according to the applicable federal tax brackets.
- Your eligibility for tax credits and deductions: Your AGI also determines whether you’re eligible for specific tax deductions (like mortgage interest or student loan interest) and credits (such as the Child Tax Credit or the American Opportunity Credit).
If your AGI falls below a certain threshold, you may qualify for tax credits, like the Earned Income Tax Credit (EITC), or deductions for medical expenses, mortgage interest, or student loan interest.
Here are some ways that deductions can be applied to gross income to arrive at AGI:
Important
Eligible educators can deduct up to $300 of unreimbursed expenses.
All these expenses are standard above-the-line deductions that can take a while to sort through, but it’s well worth taking advantage of every tax break you can find.
Below-the-line deductions, such as charitable donations or medical expenses, can be subtracted from your AGI after it’s been calculated. These are itemized deductions and are listed on Schedule A and reported on Form 1040.
Medical expenses must exceed 7.5% of your AGI to qualify for the deduction. Deductions for cash contributions to charities are generally limited to 60% of your AGI, but 20%, 30%, or 50% may apply in some cases.
The total amount of these deductions will likely determine whether you use the standard deduction or itemize your deductions.
The Standard Deduction
The standard deduction is available to all taxpayers and differs according to filing status. You can take the standard deduction or itemize your deductions. Most people go the route that reduces their taxable income the most. If your itemized deductions (like medical expenses, charitable contributions, etc.) exceed the standard deduction, you may benefit from itemizing, which could further reduce your taxable income.
The standard deduction is adjusted every year to keep up with inflation.
Calculating AGI
Start with your gross income to figure out your AGI. Your gross income is all the money you’ve earned during the calendar year. Now subtract all qualified deductions that the IRS allows. The result is your AGI.
Your deductions are estimated and listed when you file your tax return. Above-the-line deductions are listed on Schedule 1 and reported on Form 1040. Itemized deductions are listed on Schedule A and are also reported on Form 1040.
Fast Fact
After 2019, alimony is not an allowable deduction.
Net Income vs. AGI: Key Differences
- Net Income: Used for both individuals and businesses. For individuals, it refers to take-home pay after deductions. For businesses, it refers to profit after expenses and taxes.
- AGI: Exclusively used for individual tax returns and calculated by subtracting certain IRS-approved deductions from gross income. It’s crucial for determining taxable income and eligibility for tax credits.
If you have a business as a sole proprietor or independent contractor, your profits and losses are reported on Schedule C and attached to Form 1040.
What’s the Difference Between Gross Income and Adjusted Gross Income?
Gross income includes all income from any source, such as wages, bonuses, interest, and capital gains. AGI is your gross income minus specific allowable deductions. Reducing gross income to AGI lowers your taxable income and can reduce the amount of tax you owe. These deductions include things like student loan interest and educator expenses.
Is Net or Gross Income Higher?
Gross income is always higher than net income. Gross income is the total income before deductions, while net income is what remains after deductions (like taxes and benefits) are subtracted.
What Is the Meaning of Annual Net Income?
Annual net income refers to the total amount you take home in a year after all deductions, including taxes, retirement contributions, and healthcare costs, are accounted for.
The Bottom Line
Net income and adjusted gross income play key roles in understanding your financial situation, but they serve different purposes. Net income is what you take home after deductions, while AGI is used to determine your tax liability and eligibility for certain credits and deductions.
When preparing your taxes, it’s important to understand both figures. AGI is the starting point for calculating your tax bill, while net income helps you understand your actual take-home pay.
