Taxable Income

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. It can be described broadly as adjusted 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 is generally less than adjusted gross income because of deductions that reduce it.

Taxable Income

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 dividends and interest income.

When it comes to deductions, the IRS offers individual tax filers the option to claim the standard deduction or 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 their business expenses from 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.

Calculating 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 qualifying individual 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 2021 tax year, individual tax filers can claim a $12,550 standard deduction ($12,950 for 2022) or $18,800 ($19,400 for 2022) if they are heads of households. For those who are married filing jointly, the standard deduction is $25,100 ($25,900 for 2022).

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 made, 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, and qualified 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, then 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 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).

Article Sources

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