What Is Taxable Income?
Taxable income is the portion of your gross income used to calculate how much tax you owe in a given tax year. Itcan be described broadly asadjusted gross income (AGI) minus allowable itemized or standard deductions. Taxable income includes wages, salaries, bonuses, and tips, as well as investment income and various types of unearned income.
Key Takeaways
- Taxable income is the portion of your gross income that the IRS deems subject to taxes.
- It consists of both earned and unearned income.
- Taxable income comes from compensation, businesses, partnerships, and royalties, among other sources.
- Taxable income is generally less than adjusted gross income because of deductions that reduce it.
- You can begin calculating your taxable income by determining your filing status and gathering the documents related to all your income sources.
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Understanding Taxable Income
Taxable income consists of both earned and unearned income. Unearned income that is considered taxable includes canceled debts, government benefits (such as unemployment benefits and disability payments), strike benefits, and lottery payments. Taxable income also includes earnings generated from appreciated assets that have been sold during the year and from dividendsand interestincome.
When it comes to deductions, the IRS offers individual tax filers the option to claim thestandard deductionor a list of itemized deductions. Itemized deductions include interest paid on mortgages, medical expenses exceeding a specific threshold (7.5% of your AGI), and a range of other expenses.
When businesses file their taxes, they do not report their revenue directly as taxable income. Rather, they subtract theirbusinessexpensesfrom their revenue to calculate their business income. Then, they subtract deductions to calculate their taxable income.
Tax brackets and marginal tax rates are based on taxable income, not gross income.
Sources of Taxable Income
Taxable income is any income you earn during the tax year. The most common is employee compensation. But there are other sources of income that are taxable.
Employee Compensation
As noted above, this is the most common type of taxable income. This comes in the form of salaries and wages, tips, bonuses, and fees that are paid to you by your employer. The income is reported to you on your W-2, which the company sends out to you electronically or by snail mail. This form also includes any applicable deductions to your taxable income, such as income tax, Social Security, Medicare, and 401(k) contributions, among others.
According to the IRS, people who provide childcare either in their own homes or elsewhere must include the amount they receive as taxable income. This rule also applies to any money you receive if you babysit.
If you receive certain fringe benefits as a director, partner, or through your employer, you must include their value, too. The IRS has a full list of what's taxable and exemptions on its website.
Income From Business and Investments
You are responsible for declaring any income you earn from certain types of business and investment activity. This includes any rental income you receive from properties that you own. It doesn't matter if the rental activity you receive is the result of a business, or if you earn it for a profit. Keep in mind that you may be able to declare the expenses related to the rental, which can offset the income you receive.
Income from Partnerships
The IRS doesn't tax partnership entities but any income, deductions, and losses that stem from these entities are passed through to individual partners. As such, the partnership doesn't pay taxes. If you're a partner, you must declare any pass-throughs on your annual tax return. This must occur even if the pass-through doesn't apply to you directly.
Income from S Corporations
Just like a partnership, this type of corporation doesn't pay any income tax on earnings. This is passed through to shareholders based on their ownership stake in the S corporation. if you're a shareholder, earnings, losses, and deductions are reported on your personal income tax return.
Other Sources
- Bartering: Bartering involves an exchange of goods and services rather than cash. So if you fix the electrical system in someone's home and they pay you with a similar service (like fixing your plumbing) rather than cash, the value of that service is considered taxable income.
- Digital currencies: Activities related to these alternative currencies are considered taxable income. You must declare anything related to the sale, exchange, or investment of digital currencies like bitcoin.
- Royalties: You also must declare royalties as taxable income that you earn on intellectual property (copyrights, patents, trademarks, etc.) and oil, gas, and mineral properties.
How to Calculate Taxable Income
Here's a step-by-step guide to calculating taxable income.
Step 1: Determine Your Filing Status
To calculate your taxable income for an individual tax return, you first need to determine your filing status. If you are unmarried, you can file your taxes either as a single filer or, if you have a qualifying person for whom you pay more than half of the support and housing costs, as head of household (HOH).
If you are married, you will most likely want to file as married filing jointly. However, there are some limited instances when it may make sense to file as married filing separately.
Step 2: Gather Documents for all Sources of Income
When you know your filing status, you will need to gather documents for all sources of income for yourself, your spouse (if applicable), and any dependents (if applicable). The total of all these sources of income is known as your gross income. Below are the most common tax forms that you will need in order to calculate your gross income.
- Form W-2 shows the income you earned through services performed as an employee.
- If you worked a contract job or side gig, then you will need a Form 1099-NEC (nonemployee compensation). It reports income earned while working for a non-employer person or entity (when those amounts are greater than $600).
- Form 1099-MISC reports amounts earned (greater than $600) from other income sources, including rents, prizes, fishing boat proceeds, or crop insurance payments.
- If you earned more than $10 in interest during the tax year, then you will receive a Form 1099-INT from your financial institution.
Step 3: Calculate Your Adjusted Gross Income (AGI)
The next step is to calculate your AGI. Your AGI is the result of taking certain “above-the-line” adjustments to your gross income, such as contributions to a qualifyingindividual retirement account (IRA), student loan interest, and certain education expenses.
These items are referred to as “above the line” because they reduce your income before taking any allowable itemized deductions or standard deductions.
Step 4: Calculate Your Deductions (Standard or Itemized)
The next step is to calculate your deductions. As mentioned above, you can either take the standard deduction or itemize your deductions.
The standard deduction is a set amount that tax filers can claim if they don’t have enough itemized deductions to claim.For the 2024 tax year, individual tax filers can claim a $14,600 standard deduction (up from $13,850 for 2023) or $21,900 (up from $20,800 for 2023) if they are heads of households. For those who are married filing jointly, the standard deduction is $29,200 (up from $27,700 for 2023).
If you plan to itemize deductions rather than take the standard deduction, these are the records most commonly needed:
- Property taxes and mortgage interest paid. This typically appears on a Form 1098, Mortgage Interest Statement, which you will receive from your mortgage lender. If you have no mortgage or do not have an escrow account paying your property taxes, then you will need to keep a record of your property tax payments separately.
- State and local taxes paid. This is on the W-2 form if you work for an employer. If you are an independent contractor, then you will need a record of the estimated taxes you made quarterly throughout the year.
- Charitable donations. Charitable donations are a tax-deductible expense, but the amount you can claim is limited to a percentage of your AGI in most years.
- Educational expenses. Be aware that if you pay qualified higher-education expenses with a student loan, then they must be claimed in the year when the expenses are incurred, not in the year when the loan proceeds are received or repaid.
- Unreimbursed medical bills. You can deduct the amount of unreimbursed medical expenses that exceed 7.5% of your AGI (the threshold is typically between 7.5% and 10% of AGI in any normal tax year).
Owners of sole proprietorships, partnerships, S corporations, and some trusts and estates may be eligible for a qualified business income (QBI) deduction, which allows eligible taxpayers to deduct up to 20% of QBI, real estate investment trust (REIT) dividends, andqualified publicly traded partnership (PTP) income. If you are an independent contractor, then your work will most likely qualify for this special deduction.
Step 5: Calculate Taxable Income
For the final step in calculating your taxable income, you will need to take your AGI, calculated above, and subtract all applicable deductions.
As part of the American Rescue Plan, student loan forgiveness issued from Jan. 1, 2021, to Dec. 31, 2025, will not be taxable to the recipient.
Taxable Income vs. Nontaxable Income
The IRS considers almost every type of income to be taxable, but a small number of income streams are nontaxable. For example, if you are a member of a religious organization who has taken a vow of poverty, work for an organization run by that order, and turn your earnings over to the order, then your income is nontaxable.
Similarly, if you receive an employee achievement award, its value is not taxable as long as certain conditions are met. If someone dies and you receive a life insurance payment, then that is nontaxable income as well.
Different tax agencies define taxable and nontaxable income differently. For example, while the IRS considers lottery winnings to be taxable income in the United States, the Canada Revenue Agency considers most lottery winnings and other unexpected one-time windfalls to be nontaxable.
What Does Taxable Income Mean?
The term taxable income refers to any gross income earned that is used to calculate the amount of tax you owe. Put simply, it is your adjusted gross income less any deductions. This includes any wages, tips, salaries, and bonuses from employers. Investment and unearned income are also included.
What Is Unearned Income?
Examples of unearned income subject to taxation by federal or state authorities include interest, dividends, and rents, along with capital gains. Other forms of taxable income can derive from loans that have been forgiven, government benefits (like disability or unemployment benefits), and winnings from casinos or lotteries.
How Is Taxable Income Calculated?
Taxable income is calculated by adding up all sources of income, excluding nontaxable items, and subtracting credits and deductions.
What Is Nontaxable Income?
Examples of nontaxable income include earnings made from a religious or charitable organization that are subsequently returned to that organization. Another example can be an employee achievement award, as long as certain conditions are met. If someone dies and you receive a life insurance benefit, that is also nontaxable income (although it may subject you to an estate tax).
How Do I Lower My Taxable Income?
Ending the year with a taxable income can put you into a higher tax bracket, which means you'll have a higher tax bill. Most people lower this figure by taking the standard deduction when they file their return. Or, if you itemize, make sure you factor in every deduction possible. But there are ways to lower your taxable income even before you file, such as contributing to a retirement account like a 401(k) or an individual retirement account or setting money aside in a flexible spending or health savings account.
The Bottom Line
Income is any compensation you receive for providing a service. The most common form is, of course, money. But what most people don't realize is that there are other forms of income, including property and services in-kind.—and all of these are taxable. Knowing what to include can make filing your taxes easy and hassle-free. To avoid any complications, use the information and tips above to ensure that you calculate and declare your taxable income accurately.
