Adjusting Gross Income with Self Employment and Other Items
Adjusted Gross Income (AGI) is a tax term representing your gross income minus any allowable deductions. It’s needed for determining your taxable income and your eligibility for various tax credits and deductions. Let’s break down the components relevant to self-employed individuals and other pertinent deductions.
1. Self-Employment Tax
The IRS allows you to deduct the employer-equivalent portion of your self-employment tax when calculating your AGI. This means you can deduct 50% of your self-employment tax from your gross income. This adjustment is made because, unlike traditional employees whose employers pay half of their Social Security and Medicare taxes, self-employed individuals are responsible for both halves. The deduction effectively acknowledges this disparity and lowers the self-employed taxpayer’s taxable income, though it does not affect the self-employment tax amount itself.
2. Self-Employed Health Insurance Deduction
If you’re self-employed and pay for your own health insurance, you may be able to deduct premiums you paid for medical, dental, and qualified long-term care insurance for yourself, your spouse, and your dependents. This deduction is taken as an adjustment to income, so it directly decreases your AGI. It’s worth noting that you cannot claim this deduction if you’re eligible to participate in a health insurance plan maintained by your or your spouse’s employer.
3. SEP IRAs
A Simplified Employee Pension (SEP) IRA is a retirement plan that allows business owners to make contributions toward their own retirement and their employees’ retirements without getting involved in a more complex qualified plan. Contributions made to a SEP IRA are tax-deductible and can significantly lower AGI. The contribution limit is the lesser of 25% of compensation or a specific cap set by the IRS ($61,000 for 2022, as an example).
4. Alimony Payments
For divorces finalized before 2019, alimony payments made to a former spouse are deductible, and alimony received is taxable income. However, for divorces and separation agreements finalized after December 31, 2018, alimony payments are no longer deductible by the payer, nor are they taxable to the recipient.
5. Capital Losses
If you sell property or investments for less than what you paid for them, the resulting capital losses can offset any capital gains and reduce your taxable income. If netting capital gains and losses results in a total net capital loss, then you can deduct up to a certain yearly limit (for example, $3,000) from gross income.
6. Moving Expenses
Moving expenses for work-related relocations are no longer deductible for most taxpayers due to the Tax Cuts and Jobs Act of 2017. However, active-duty members of the Armed Forces moving due to a permanent change of station can still deduct unreimbursed moving expenses.
Let’s use an example that encompasses self-employment tax, self-employed health insurance, and contributions to a SEP IRA to illustrate how these factors can impact a self-employed individual’s Adjusted Gross Income (AGI).
Self-Employment Example:
- Annual Net Profit from Self-Employment: $100,000
- Self-Employed Health Insurance Premiums Paid: $6,000 for the year
- Contribution to SEP IRA: $15,000 for the year
- Self-Employment Tax: $15,300
Step 1: Deduct Half of the Self-Employment Tax
You can deduct half of the self-employment tax when calculating your AGI.
Deduction for Half of Self-Employment Tax = $15,300 / 2 = $7,650
Step 2: Deduct Self-Employed Health Insurance
The premiums paid for self-employed health insurance are deductible from your gross income.
Self-Employed Health Insurance Deduction = $6,000
Step 3: Deduct SEP IRA Contribution
Contributions to a SEP IRA are deductible from your gross income up to the lesser of a percentage of net earnings (for example, 25%) or a specific cap set by the IRS (in this example, $15,000).
Net Earnings = Profit from Self-Employment – Half of the Self-Employment Tax
Net Earnings = $100,000 – $7,650 = $92,350
$92,350 x 25% = $23,087.50
Since the percentage of net earnings ($23,087.50) is greater than the cap set by the IRS ($15,000), we use the IRS cap for the deduction.
Step 4: Calculate Adjusted Gross Income (AGI)
Now, subtract the deductions from your net earnings from self-employment to find your AGI.
AGI = $100,000 − $7,650 − $6,000 − $15,000 = $71,350
