What Is Taxable Income?
Taxable income is the portion of an individual's or company's income used to calculate how much tax they owe the government in a given tax year. It can broadly be described 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.
- Taxable income is the portion of a person’s gross income that the government deems subject to taxes.
- Taxable income consists of both earned and unearned income.
- Taxable income is generally less than adjusted gross income because of deductions that reduce it.
Understanding Taxable Income
Unearned income considered to be taxable income includes canceled debts, alimony payments, child support, 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 Internal Revenue Service (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 AGI for 2020), 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.
While canceled debts are usually taxable, Congress exempted forgiven Paycheck Protection Program loans from federal taxation. Some states, however, may treat the forgiven amount as taxable income or disallow deductions for expenses paid for by the loan.
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 one-half of the support and housing costs, as a head of household. If you are married, you will most likely want to file as married filing jointly (MFJ). However, there are some limited instances where it may make sense to file as married filing separately (MFS).
Step 2: Gather documents for all sources of income
Once 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 you will need 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, you will need a Form 1099-NEC (non-employee 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, you will receive a Form 1099-INT from your financial institution.
Step 3: Calculate your adjusted gross income
The next step is to calculate your adjusted gross income (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 educator expenses. These items are referred to as "above-the-line" because they reduce your income before taking any allowable itemized deductions or the standard deductions.
For the 2020 tax year, the CARES Act allows taxpayers who elect the standard deduction to take a $300 "above-the-line" deduction for cash contributions to charity.
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 you can itemize your deductions.
The standard deduction is a set amount tax filers can claim if they don’t have enough itemized deductions to claim. For 2021, individual tax filers can claim a $12,400 standard deduction ($24,800 for married filing jointly and $18,650 for heads of household). These figures rise to $12,550, $25,100, and $18,800 for 2021.
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, you will need to keep a record of your property tax payments separately.
- State and local taxes you paid. This is on the W-2 form if you work for an employer. If you are an independent contractor, you will need a record of the estimated tax payments you made quarterly throughout the year.
- Charitable donations. Charitable donations are a tax-deductible expense; however, the amount you can claim is limited to a percentage of your adjusted gross income (AGI) in most years.
- Educational expenses. Be aware, if you pay qualifying educational expenses with a student loan, it must be claimed in the year the expenses are made, not in the year the loan proceeds are received or repaid.
- Unreimbursed medical bills. For 2020, 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, your work will most likely qualify for this special deduction.
As part of the American Rescue Plan, which was passed by President Joe Biden on March 11, 2021, a Senate amendment made $10,200 ($20,400 for married couples filing jointly) of unemployment compensation paid in 2020 tax-free at the federal level for anyone earning less than $150,000. Since states may not conform with the federal exemption, review your state return and this list to see how your state treats unemployment income. If you filed your tax return before March 31, 2021, the IRS will adjust it automatically. The Act also includes a provision that student loan forgiveness issued between December 30, 2020, and January 1, 2026, will not be taxable to the recipient.
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.
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, 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, that is nontaxable income as well.
Different tax agencies define taxable and nontaxable income differently. For example, while in the United States the IRS considers lottery winnings to be taxable income, the Canada Revenue Agency considers most lottery winnings and other unexpected one-time windfalls to be nontaxable.
Frequently Asked Questions
What Is Considered Taxable Income?
Taxable income includes wages, salaries, bonuses, and tips, as well as investment income and various types of unearned income. Unearned income considered to be taxable income includes canceled debts, alimony payments, child support, 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.
How to Calculate Taxable Income for an Individual Tax Return?
The process starts with determining your filing status (single, married, etc.) and gathering documents for all sources of income (W2, 1099, etc.). The next step is calculating your adjusted gross income (AGI), which is "above-the-line" adjustments to your gross income, such as contributions to a qualifying individual retirement account (IRA). Then comes the crucial step of calculating your deductions, which can either be standard and/or itemized deductions. Your taxable income is what's left after subtracting all applicable deductions from AGI.
What Are Examples of Nontaxable Income?
The IRS recognizes some income streams as 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, 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, that is nontaxable income as well.