Module Overview

Adjustments and deductions reduce Gross Income to reflect varying financial circumstances, business realities, and certain expenditures that Congress has deemed appropriate to incentivize or recognize. The importance of deductions and adjustments stems from principles of both equity and economic policy. From an equity perspective, these provisions acknowledge that taxpayers have diverse financial situations. It would be unfair to tax the gross receipts of a business without allowing for the deduction of the costs of running that business. Similarly, certain personal expenditures, like significant medical expenses, can demonstrably reduce a taxpayer’s capacity to pay taxes. From an economic and social policy viewpoint, Congress strategically uses deductions and adjustments to encourage specific behaviors and support societal goals. Deductions for retirement savings incentivize individuals to plan for their future, while deductions for charitable contributions encourage philanthropic giving. Adjustments to Gross Income, often referred to as “above-the-line” deductions, which lead us to Adjusted Gross Income (AGI). Deductions from Adjusted Gross Income, or “below-the-line” deductions, include the greater of standard deduction and itemized deduction, and Qualified Business Income (QBI) deduction.

Adjustments to Gross Income (§ 62)

The Internal Revenue Code Section 62, titled “Adjusted Gross Income Defined,” sets out the definitive list of Adjustments to Gross Income. Section 62(a) provides a comprehensive catalog of allowable deductions. The following discussion highlights some of the most common and relevant adjustments for individual taxpayers:

Trade or Business Deductions (§ 62(a)(1)):

This adjustment allows self-employed individuals and business owners to deduct ordinary and necessary expenses directly connected with carrying on a trade or business. These are the day-to-day costs of operating a business. It’s important to distinguish between business expenses and personal expenses; only business-related costs are deductible as adjustments.

Deduction for Contributions to Traditional IRAs (§ 62(a)(7)):

To encourage retirement savings, the tax law allows eligible taxpayers to deduct contributions made to a Traditional Individual Retirement Account (IRA). This deduction helps individuals save for retirement on a tax-deferred basis. There are limitations on the amount that can be contributed and deducted, and these limitations can vary based on factors like filing status, age, and whether the taxpayer (or their spouse, if married) is covered by a retirement plan at work.

Student Loan Interest Deduction (§ 62(a)(1)):

Recognizing the burden of student loan debt, the tax code permits a deduction for interest paid on qualified student loans. This deduction is subject to limitations, including a maximum annual deduction amount and income-based phase-outs. The loan must be for qualified higher education expenses, and the student must be the taxpayer, their spouse, or a dependent when the debt was incurred.

Health Savings Account (HSA) Deduction (§ 62(a)(16)):

Health Savings Accounts (HSAs) are tax-advantaged savings accounts that can be used to pay for qualified medical expenses. Individuals who are covered under a high-deductible health plan (HDHP) may be eligible to contribute to an HSA. Contributions to an HSA are deductible, earnings grow tax-free, and withdrawals for qualified medical expenses are also tax-free, offering a triple tax benefit.

Moving Expenses (For Members of the Armed Forces) (§ 62(a)(8)):

It is important to note that for most taxpayers, the deduction for moving expenses was suspended by the Tax Cuts and Jobs Act (TCJA) of 2017. However, an exception remains for members of the Armed Forces on active duty who move pursuant to a military order related to a permanent change of station. In these specific circumstances, moving expenses are still deductible as an adjustment.

One-Half of Self-Employment Tax (§ 62(a)(14)):

Employees and employers share the burden of Social Security and Medicare taxes. However, self-employed individuals are responsible for paying both the employer and employee portions of these taxes, collectively known as self-employment tax. To partially offset this, self-employed individuals are permitted to deduct one-half of their self-employment tax as an adjustment to gross income. This helps to equalize the tax burden between employees and the self-employed.

Adjustments to Gross Income are critical in moving from the broad concept of Gross Income to the more refined measure of Adjusted Gross Income (AGI). They are often advantageous due to their “above-the-line” nature, directly reducing AGI, which in turn can positively influence various other aspects of your tax calculation. Remember, AGI is not your final taxable income, but it is a vital intermediate step in the process.

Deductions from Adjusted Gross Income (§ 63)

Deductions from Adjusted Gross Income are often called “below-the-line” deductions, and are subtracted after AGI is calculated. Taxpayers generally have a choice in this stage: they can take the standard deduction or, if eligible, choose to itemize deductions. These are mutually exclusive options – a taxpayer must choose one or the other, not both. The general rule is to choose the option that results in the larger deduction, thereby further reducing taxable income.

The framework for deductions from AGI is established in Internal Revenue Code Section 63, “Taxable Income Defined.” Specifically, §63(b) defines the standard deduction, and §63(d) defines itemized deductions.

The Standard Deduction vs. Itemized Deduction

Standard Deduction

The standard deduction is a fixed dollar amount that Congress sets annually based on filing status (Single, Married Filing Jointly, Head of Household, etc.). It is a simplified deduction designed to ease tax preparation for many taxpayers, particularly those with relatively straightforward financial situations. For taxpayers whose qualifying itemized deductions are less than the standard deduction amount, it is generally more beneficial to claim the standard deduction. The specific dollar amounts for the standard deduction are updated each year to account for inflation. Filing status, taxpayer’s age, and blindness will determine the amount of the standard deduction.

Taxpayers who are age 65 or older and/or blind are eligible for an additional standard deduction amount. This additional amount is also set annually and varies depending on filing status. For example, a single individual who is both age 65 or older and blind would receive two additional standard deduction amounts on top of the base standard deduction for single filers. Refer to §63(f) for the specific rules and amounts. There are some limitations on who can claim the full standard deduction . For example, the standard deduction is limited for individuals who can be claimed as a dependent on another person’s tax return and for certain other special situations.

Itemized Deduction

Itemized deductions are specific expenses that Congress has explicitly allowed taxpayers to deduct from their AGI. These are listed in Part VI of Subchapter B of Chapter 1 of the IRC, titled “Itemized Deductions for Individuals and Corporations.” Taxpayers may choose to itemize if their total qualifying itemized deductions exceed their applicable standard deduction amount. Itemizing can be more beneficial for taxpayers with significant expenses in categories like medical care, state and local taxes, home mortgage interest, charitable contributions, and casualty losses (within limitations).

Common itemized deductions include medical expenses (§213), state and local taxes (§164), mortgage and investment interest (§163), charitable contributions (§170), and casualty and theft losses (§165). Other less frequent itemized deductions exist, such as gambling losses (deductible up to the amount of gambling winnings). Many miscellaneous itemized deductions subject to the 2% AGI floor were suspended by the TCJA for tax years 2018–2025.

Taxpayers are required to compute their total itemized deductions and compare this figure to the standard deduction available for their filing status. They may claim only one of these two options, and generally select the greater amount in order to minimize their taxable income.

Qualified Business Income Deduction (QBI) (§ 199A)

The Qualified Business Income Deduction (QBI), often called the “pass-through deduction,” was enacted as part of the Tax Cuts and Jobs Act (TCJA) in 2017. It allows many self-employed individuals and owners of pass-through entities (such as sole proprietorships, partnerships, and S corporations) to deduct up to 20 percent of their qualified business income from taxable income. Although technically listed as an adjustment under §62(a)(22), the deduction is calculated separately after adjusted gross income (AGI) and requires a multi-step process. The rules distinguish between specified service trades or businesses (SSTBs) and non-SSTBs, apply income thresholds that phase in or phase out eligibility, and impose limits based on W-2 wages paid and the unadjusted basis of qualified property (§199A). These provisions mean that high-income taxpayers engaged in certain professional services, such as law or accounting, may face partial or full restrictions on the deduction. Because of these layers of limitations and computational rules, the QBI deduction provides significant tax relief for many small business owners but remains one of the most complex provisions in the individual tax system.

Steps in Calculating the QBI Deduction

1. Determine Qualified Business Income: Identify the net income from qualified trades or businesses, excluding items such as capital gains, dividends, and certain interest.
2. Apply the 20 Percent Calculation: Compute 20 percent of the qualified business income.
3. Compare to the Overall Limitation: Compare the 20 percent of QBI to 20 percent of taxable income (excluding net capital gains). The deduction is limited to the smaller of these two amounts.
4. Apply Wage and Property Limitations (if income exceeds thresholds): For higher-income taxpayers, the deduction may be limited to the greater of (a) 50 percent of W-2 wages paid by the business or (b) 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis of qualified property.
5. Account for Specified Service Trades or Businesses (SSTBs): If the business is a specified service trade or business, the deduction phases out once taxable income exceeds the statutory threshold amounts.
6. Combine and Report the Deduction: After applying all relevant limitations, the allowable deduction is reported as a separate line item below AGI and reduces taxable income accordingly.