Prior to preparing and filing a tax return, do yourself a favor by gaining an understanding of commonly used tax terms including earned income, gross income, adjusted gross income (AGI) and modified adjusted gross income (MAGI). Each of these is used in a different way to determine total taxable income and, ultimately, your total tax obligation based on your net income for the year. The distinctions between earned income and gross income are especially important to understand in relation to tax accounting.
According to the U.S. Internal Revenue Service (IRS), earned income includes only certain earnings over the course of any given year. These specific income items include your wages or salary, commissions and bonuses, as well as business income net of expenses if you are self-employed. Earned income may also include the fair market value of certain fringe benefits that are deemed taxable through an employer under the direction of the IRS guidelines, long-term disability benefits received prior to minimum retirement age and strike benefits from involvement in union activities. Earned income does not include the same media of income that are accounted for under the purview of gross income.
Gross income is defined by the IRS as all facets of income you have received throughout any given year. In addition to the specific items listed under earned income, your gross income also includes investment income in the form of interest and dividends, as well as your retirement income derived from retirement account withdrawals. Additionally, gross income includes Social Security benefits, as well as Social Security disability benefits, unemployment payments, alimony and child support.
Gross income is considered total income for the purpose of tax preparation and filing, and it is used to further determine total tax liability. This figure is also the starting point for calculating adjusted gross income, which is your income after deductions, and modified adjusted gross income, which is similar to adjusted gross income but with certain deductions added back to the total.
The IRS uses your earned income total to determine whether certain financial actions can be taken throughout the year. For instance, you can contribute to an individual retirement account only if you have earned income for the year, and that contribution may not exceed your total earned income for that year. Your gross annual income is used to determine what deductions, exemptions and credits are available to you to determine your total taxable income and then your total tax obligations for the year.
Earned income, gross income, adjusted gross income and modified adjusted gross income provide the foundation for tax preparation and filing. The difference between earned income and gross income is an important one in your tax accounting.