At first glance, the definition of gross income seems fairly straightforward. As described in 26 U.S.C. § 61, gross income is “all income, from whatever source derived”. This includes income from wages, business activities, gains from property deals, alimony, dividends, etc., etc.
Gross income is essentially all the money that a person earns during the tax year. If that individual uses the cash method of accounting, they must include income in their gross income calculations for the year that the income was actually received. (In other words, the year in which they actually had the money in their possession.) If the taxpayer uses the accrual method of accounting, the income belongs to the gross income calculations for the year in which they earned the money, not necessarily the year they received it. Most individuals use the cash method of accounting, however.
In addition, some sources of income are specifically excluded from the gross income calculation. Life insurance proceeds and income that goes directly into 401(k) plans are not considered gross income, for example, nor are Social Security benefits. These types of income are known as “exempt” income since they are not a part of an individual’s gross income calculation.
Gross income itself is only a starting point for calculating an individual’s tax liability. Once gross income is calculated, a taxpayer can reduce the amount of income through the use of deductions. The resulting figure is known as the individual’s adjusted gross income.
A taxpayer’s gross income is the sum of all of the taxpayer’s income from all sources, minus a few items that are exempt from taxation. Once a taxpayer has calculated their gross income, however, they can remove some additional sources of income from their income calculation. The figure that results from these removals, or “adjustments,” is the taxpayer’s “adjusted gross income.”
The list of income sources that taxpayers can remove from gross income to arrive at their adjusted gross income is contained in the United States Tax Code at 26 U.S.C. § 62. It includes such things as business deductions, certain expenses of military reservists, and certain expenses of schoolteachers.
Why does the government distinguish between gross income and adjusted gross income? As with all things related to the tax code, the answer is complicated. The basic answer, however, is that the federal government uses adjusted gross income to determine eligibility for certain programs.
The government has determined that some types of income shouldn’t disqualify taxpayers from certain programs. Thus, a taxpayer might have a gross income that would not fall within the income range for a certain program, but the government allows the taxpayer to adjust their gross income by removing certain items from the calculation. The resulting adjusted gross income figure could potentially fall within the program’s range.
Taxpayers shouldn’t confuse the income adjustments for adjusted gross income with the standard or itemized deductions that reduce a person’s income even further. A taxpayer’s adjusted gross income minus deductions is known as their “taxable income,” and is the figure that is used to calculate the amount of tax owed for the year.
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