What Is the Accumulation Phase?

Accumulation phase has two meanings for investors and those saving for retirement. It refers to the period when an individual is working and planning and ultimately building up the value of their investment through savings. The accumulation phase is then followed by the distribution phase, in which retirees begin accessing and using their funds.

How the Accumulation Phase Works

The accumulation phase is also a specific period when an annuity investor is in the early stages of building up the cash value of the annuity. This building phase is followed by the annuitization phase, where payments are paid out to the annuitant.

The accumulation phase essentially begins when a person starts saving money for retirement and ends when they begin taking distributions. For many people, this starts when they begin their working life and ends when they retire from the work world. It is possible to start saving for retirement even before beginning the work phase of one’s life, such as when someone is a student, but it is not common. Typically, joining the workforce coincides with the start of the accumulation phase.

Importance of the Accumulation Phase

Experts state that the sooner an individual begins the accumulation phase, the better, with the long-term financial difference between beginning to save in one’s 20s vs. in the 30s substantial. Postponing consumption by saving during an accumulation period will most often increase the amount of consumption one will be able to have later. The earlier the accumulation period is in your life, the more advantages you will have, such as compounding interest and protection from business cycles.

In terms of annuities, when a person invests money in an annuity to provide income for retirement, they are at the accumulation period of the annuity’s life span. The more invested during the accumulation phase, the more will be received during the annuitization phase.

Real-World Examples

There are many income streams that an individual can build up during the accumulation phase, starting from when they first enter the workforce, or in some cases, sooner. Here are a few of the more popular options.

• Social Security: This is a contribution automatically deducted from every paycheck you receive.
• 401(k): This is an optional tax-deferred investment that can be made paycheck-to-paycheck, monthly, or yearly provided your employer offers such an option. The amount you can set aside has yearly limits and also depends on your income, age, and marital status.
• IRAs: An Individual Retirement Account can be either pretax or after-tax, depending on which option you choose. The amount you can invest varies year-to-year, as set out by the Internal Revenue Service (IRS), and depends on your income, age, and marital status.
• Investment portfolio: This refers to an investor’s holdings, which can include assets such as stocks, government, and corporate bonds, Treasury bills, real estate investment trusts (REITs), exchange-traded funds (ETFs), mutual funds, and certificates of deposits. Options, derivatives and physical commodities like real estate, land and timber can also be included in the list.
• Deferred payment annuities: These annuities offer tax-deferred growth at a fixed or variable rate of return. They allow individuals to make monthly or lump-sum payments to an insurance company in exchange for guaranteed income down the line, typically 10 years or more.
• Life insurance policies: Some policies can be useful for retirement, such as if an individual pays an after-tax, fixed amount annually that grows based on a particular market index. The policy would need to be the kind that allows the individual to withdraw in retirement the principal and any appreciation from the policy essentially tax-free.

What Is an Audit?

The term audit usually refers to a financial statement audit. A financial audit is an objective examination and evaluation of the financial statements of an organization to make sure that the financial records are a fair and accurate representation of the transactions they claim to represent. The audit can be conducted internally by employees of the organization or externally by an outside Certified Public Accountant (CPA) firm.

Understanding Audits

Almost all companies receive a yearly audit of their financial statements, such as the income statement, balance sheet, and cash flow statement. Lenders often require the results of an external audit annually as part of their debt covenants. For some companies, audits are a legal requirement due to the compelling incentives to intentionally misstate financial information in an attempt to commit fraud. As a result of the Sarbanes-Oxley Act (SOX) of 2002, publicly traded companies must also receive an evaluation of the effectiveness of their internal controls.

Standards for external audits performed in the United States, called the generally accepted auditing standards (GAAS), are set out by Auditing Standards Board (ASB) of the American Institute of Certified Public Accountants (AICPA). Additional rules for the audits of publicly traded companies are made by the Public Company Accounting Oversight Board (PCAOB), which was established as a result of SOX in 2002. A separate set of international standards, called the International Standards on Auditing (ISA), were set up by the International Auditing and Assurance Standards Board (IAASB).

Types of Audits

External Audits

Audits performed by outside parties can be extremely helpful in removing any bias in reviewing the state of a company’s financials. Financial audits seek to identify if there are any material misstatements in the financial statements. An unqualified, or clean, auditor’s opinion provides financial statement users with confidence that the financials are both accurate and complete. External audits, therefore, allow stakeholders to make better, more informed decisions related to the company being audited.

External auditors follow a set of standards different from that of the company or organization hiring them to do the work. The biggest difference between an internal and external audit is the concept of independence of the external auditor. When audits are performed by third parties, the resulting auditor’s opinion expressed on items being audited (a company’s financials, internal controls, or a system) can be candid and honest without it affecting daily work relationships within the company.

Internal Audits

Internal auditors are employed by the company or organization for whom they are performing an audit, and the resulting audit report is given directly to management and the board of directors. Consultant auditors, while not employed internally, use the standards of the company they are auditing as opposed to a separate set of standards. These types of auditors are used when an organization doesn’t have the in-house resources to audit certain parts of their own operations.

The results of the internal audit are used to make managerial changes and improvements to internal controls. The purpose of an internal audit is to ensure compliance with laws and regulations and to help maintain accurate and timely financial reporting and data collection. It also provides a benefit to management by identifying flaws in internal control or financial reporting prior to its review by external auditors.

Internal Revenue Service (IRS) Audits

The Internal Revenue Service (IRS) also routinely performs audits to verify the accuracy of a taxpayer’s return and specific transactions. When the IRS audits a person or company, it usually carries a negative connotation and is seen as evidence of some type of wrongdoing by the taxpayer. However, being selected for an audit is not necessarily indicative of any wrongdoing.

IRS audit selection is usually made by random statistical formulas that analyze a taxpayer’s return and compare it to similar returns. A taxpayer may also be selected for an audit if they have any dealings with another person or company who was found to have tax errors on their audit.

There are three possible IRS audit outcomes available: no change to the tax return, a change that is accepted by the taxpayer, or a change that the taxpayer disagrees with. If the change is accepted, the taxpayer may owe additional taxes or penalties. If the taxpayer disagrees, there is a process to follow that may include mediation or an appeal.

What Is the Applicable Federal Rate (AFR)?

The applicable federal rate (AFR) is the minimum interest rate that the Internal Revenue Service (IRS) allows for private loans. Each month the IRS publishes a set of interest rates that the agency considers the minimum market rate for loans. Any interest rate that is less than the AFR would have tax implications. The IRS publishes these rates in accordance with Section 1274(d) of the Internal Revenue Code.

Understanding the Applicable Federal Rate (AFR)

The AFR is used by the IRS as a point of comparison versus the interest on loans between related parties, such as family members. If you were giving a loan to a family member, you would need to be sure that the interest rate charged is equal to or higher than the minimum applicable federal rate.

The IRS publishes three AFRs: short-term, mid-term, and long-term. Short-term AFR rates are determined from the one-month average of the market yields from marketable obligations, such as U.S. government T-bills with maturities of three years or less. Mid-term AFR rates are from obligations of maturities of more than three and up to nine years. Long-term AFR rates are from bonds with maturities of more than nine years.

Example of How to Use the AFR

As of Apr. 2022, the IRS stated that the annual short-term AFR was 1.26%, the mid-term AFR was 1.87%, and the long-term AFR was 2.25%. Please bear in mind that these AFR rates are subject to change by the IRS.

Which AFR rate to use for a family loan would depend on the length of time designated for payback. Let’s say you were giving a loan to a family member for $10,000 to be paid back in one year. You would need to charge the borrower a minimum interest rate of 1.26% for the loan. In other words, you should receive $126 in interest from the loan.

In our example above, any rate below 1.26% could trigger a taxable event. For example, let’s say you gave the same loan, but you didn’t charge any interest. By not charging any interest, you would have “foregone” $126 in interest income, and according to the IRS, it would be considered a taxable gift. Any interest rate charged below the stated AFR for the particular term of the loan would be considered foregone interest and, as a result, be taxable.

Special Considerations

When preparing to make a loan between related parties, taxpayers should consider two factors to select the correct AFR. The length of the loan should correspond to the AFRs: short-term (three years or less), mid-term (up to nine years), and long-term (more than nine years).

If the lender charges interest at a lower rate than the proper AFR, the IRS may reassess the lender and add imputed interest to the income to reflect the AFR rather than the actual amount paid by the borrower. Also, if the loan is more than the annual gift tax exclusion, it may trigger a taxable event, and income taxes may be owed. Depending on the circumstances, the IRS may also assess penalties.

What Is Adjusted Gross Income (AGI)?

Adjusted gross income (AGI) is the figure that the Internal Revenue Service (IRS) uses to determine your income tax liability for the year. It is calculated by subtracting certain adjustments from gross income, such as business expenses, student loan interest payments, and other expenses. After calculating a taxpayer’s AGI, the next step is to subtract deductions to determine their taxable income.

The IRS also uses other income metrics, such as modified AGI (MAGI), for specific programs and retirement accounts.

Understanding Adjusted Gross Income (AGI)

As prescribed in the United States tax code, AGI is a modification of gross income. Gross income is simply the sum of all the money you earned in a year, which may include wages, dividends, capital gains, interest income, royalties, rental income, alimony, and retirement distributions, before tax or other deductions. AGI makes certain adjustments to your gross income to reach the figure on which your tax liability will be calculated.

Many U.S. states also use the AGI from federal returns to calculate how much individuals owe in state income taxes. States may modify this number further with state-specific deductions and credits.

Common Adjustments

The items subtracted from your gross income to calculate your AGI are referred to as adjustments to income, and you report them on Schedule 1 of your tax return when you file your annual tax return. Some of the most common adjustments are listed here, along with the separate tax forms on which a few of them are calculated:

• Alimony payments (for divorces filed before Jan. 1, 2019)
• Early withdrawal penalties on savings
• Educator expenses
• Employee business expenses for armed forces reservists, qualified performing artists, fee-basis state or local government officials, and employees with impairment-related work expenses (Form 2106)
• Health Savings Account (HSA) deductions (Form 8889)
• Moving expenses for members of the armed forces (Form 3903)
• Self-employed Simplified Employee Pension (SEP), Savings Incentive Match Plan for Employees of Small Employers (SIMPLE), and qualified plans
• Self-employed health insurance deduction
• Self-employment tax (the deductible portion)
• Student loan interest deduction

How to Calculate Adjusted Gross Income

If you use software to prepare your tax return, it will calculate your AGI once you input your numbers. If you calculate it yourself, you’ll begin by tallying your reported income for the year. That might include job income, as reported to the IRS by your employer on a W-2 form, plus other income, such as dividends and miscellaneous income, reported on 1099 forms.

Next, you add any taxable income from other sources, such as profit on the sale of a property, unemployment compensation, pensions, Social Security payments, or anything else that hasn’t already been reported to the IRS. Many of these income items are also listed on IRS Schedule 1.

The next step is to subtract the applicable adjustments to the income listed above from your reported income. The resulting figure is your AGI. To determine your taxable income, subtract either the standard deduction or your total itemized deductions from your AGI. In most cases, you can choose whichever gives you the most benefit.

For example, the standard deduction for tax returns for married couples filing jointly was $25,900 in 2022, rising to $27,700 in 2023, so couples whose itemized deductions exceed that amount would generally opt to itemize, while others would take the standard deduction.

The IRS provides a list of itemized deductions and the requirements for claiming them on its website. Your AGI also affects your eligibility for many of the deductions and credits available on your tax return. In general, the lower your AGI, the more significant the number of deductions and credits you will be eligible to claim, and the more you’ll be able to reduce your tax bill.

An Example of AGI Affecting Deductions

Let’s say you had some significant dental expenses during the year that weren’t reimbursed by insurance, and you’ve decided to itemize your deductions. You are allowed to deduct the portion of those expenses that exceed 7.5% of your AGI.

This means that if you report $12,000 in unreimbursed dental expenses and have an AGI of $100,000, you can deduct the amount that exceeds $7,500, which is $4,500. However, if your AGI is $50,000, the 7.5% reduction is just $3,750, and you’d be entitled to deduct a larger amount of that $12,000, in this case $8,250.

Adjusted Gross Income (AGI) vs. Modified Adjusted Gross Income (MAGI)

In addition to AGI, some tax calculations and government programs call for using what’s known as your modified adjusted gross income, or MAGI. This figure starts with your AGI, then adds back certain items, such as any deductions you take for student loan interest or tuition and fees.

Your MAGI is used to determine how much, if anything, you can contribute to a Roth individual retirement account (Roth IRA) in any given year. It is also used to calculate your income if you apply for Marketplace health insurance under the Affordable Care Act (ACA).

Many people with relatively uncomplicated financial lives find that their AGI and MAGI are the same number or very close.

Adjusted Gross Income vs. Gross Income vs. Taxable Income

Your gross income is all of the money you’ve earned in a year that isn’t exempt from taxation. This can be in the form of salary, wages, interest, dividends, capital gains, and so on.

Your adjusted gross income takes that amount and takes out certain qualified expenses and adjustments.

Taxpayers can then take either the standard deduction for their filing status or itemize the deductible expenses they paid during the year. You’re not permitted to both itemize deductions and claim the standard deduction. The result is your taxable income.

Frequently Asked Questions

The Bottom Line

Adjusted gross income, or AGI, is your gross income after it has been adjusted for certain qualified deductions that are permitted by the Internal Revenue Service (IRS). These qualified deductions reduce an individual’s gross income, thus reducing the taxable income that they will ultimately have to pay taxes on. You can save money come tax season by lowering your AGI, which will lower your taxable income, in turn. However, many of the adjustments allowed for AGI are specific for particular circumstances that may not apply to everyone.