2. Understanding Taxation
Sometimes you hear the phrase, adjusted gross income (AGI). Adjusted gross income refers to the amount that the government really uses for taxation purposes. For example, when you apply for financial aid on the FAFSA, you report your family’s AGI. Your AGI might go up or down from what’s reported on your W-2 because you receive income from other sources (interest on a savings account) or you paid some of your income into something the government thinks is a good idea (certain retirement accounts or college savings accounts).
Then there are deductions. You can deduct expenses like contributions to charities or interest you pay on a mortgage. The government wants you to give to charities, which often provide services that the government then doesn’t have to provide. The government also wants to encourage home ownership, so it allows deductions for mortgage interest and property taxes. If you don’t have many deductions, you still are allowed to subtract a “standard” deduction. The government wants you to prepare for your retirement and not be a future burden on them. If you participate in an employer sponsored retirement savings plan, like a 401K, these subtractions actually happen before your final income for the year is determined. If you contribute to a separate retirement savings plan outside of your employer, like an IRA, you can deduct that amount from your gross income when you file your tax return. After AGI has been determined, we still can deduct from it either by using standard deductions or itemized deductions as well as exemptions.