• Explanation

The formula used to determine an individual's taxable income includes the computation of adjusted gross income (AGI). AGI is important since it determines a taxpayer's eligibility for certain tax deductions and credits. It is calculated as follows: gross income − exclusions − adjustments for AGI.

Once AGI is computed, certain deductions are subtracted from AGI in order to determine taxable income. Deductions both for and from AGI may be subject to dollar limitations (eg, retirement plans), or subject to an AGI threshold (ie, medical expenses must exceed 7.5% of AGI to be deductible). There are some items that are not deductible for or from AGI. For example, no deduction is permitted for contributions made to qualified tuition programs because, in general, the earnings and distributions from these programs are nontaxable.

The taxpayer's AGI is $105,000 ($110,000 W-2 income − $5,000 IRA contribution). Contributions to a traditional IRA are deducted for AGI. No deduction is allowed for contributions to qualified tuition programs (Coverdell education savings plans). Although the medical expenses are limited to $4,125 ($12,000 – 7.5% of $105,000 AGI), itemized deductions are deducted from AGI.

(Choice A) AGI of $93,000 ($110,000 − $5,000 − $12,000) implies that the medical expenses are fully deductible for AGI. These expenses are itemized deductions.

(Choice B) AGI of $100,875 ($110,000 − $5,000 − $4,125) suggests that the medical expenses (after the 7.5% AGI limitation) are deductible for AGI.

(Choice C) AGI of $103,000 ($110,000 − $5,000 − $2,000) assumes contributions to the qualified tuition program are deductions for AGI. No deduction is allowed for contribution to these programs.

Things to remember:
Taxpayers are allowed certain adjustments for and from AGI when determining taxable income. It is important to know the distinction between the two types of adjustments since AGI determines the taxpayer's eligibility and limitations for certain tax deductions and credits.