Taxable Income

Most people receive income from a variety of sources, including salary from a job, Social Security benefits, returns on investments, income from a business, and more. It might be difficult to determine your taxable income and calculate how much tax you will owe because some of that money is taxable and other is not.

However, since it provides you an estimate of how much you'll owe, predicting your taxable income before submitting your tax return might help you avoid surprises. You may learn more about taxable income in this article, including how to calculate it.

What is Taxable Income ?

Taxable income is the amount of income that is subject to income tax, after all allowable deductions and exemptions have been taken into account. In other words, it's the portion of your gross income that is used to calculate your income tax liability. It can be broadly defined as adjusted gross income (AGI) less allowable standard or itemized deductions. 

The components of taxable income may include salaries, wages, tips, bonuses, business income, rental income, investment income, and any other income that you earn during the tax year.

Deductions and exemptions reduce the amount of taxable income. Deductions are expenses that are allowed to be subtracted from your income before your tax liability is calculated, such as certain business expenses, charitable contributions, and mortgage interest. Exemptions are a set amount that can be deducted from your income for each person listed on your tax return, including yourself, your spouse, and any dependents.

Once all deductions and exemptions have been accounted for, the remaining amount is considered taxable income, and the amount of tax owed is calculated based on the applicable tax rates and tax brackets.

Key Facts of Taxable Income

  • The part of your gross income that the IRS considers to be taxable is known as taxable income. Both earned and unearned income are included in it.
  • Due to deductions, taxable income is typically lower than adjusted gross income.
  • Once you've established your filing status and gathered the necessary documentation for each of your income sources, you can start figuring out your taxable income.
  • When tax season rolls around, all income that is taxable, subject to income tax and must be recorded on a tax return.

How the Taxable Income Works ?

Taxable income refers to the amount of income that is subject to income tax after deductions and exemptions have been taken into account. In general, taxable income includes all types of income, such as wages, salaries, tips, bonuses, interest income, dividend income, rental income, and capital gains.

To calculate your taxable income, you first need to determine your gross income, which is the total amount of income you received during the tax year. Next, you can deduct certain expenses, such as contributions to a traditional IRA or 401(k) plan, certain business expenses, and certain medical expenses, from your gross income to arrive at your adjusted gross income (AGI).

Your AGI is then used to determine your eligibility for certain deductions and credits. For example, some deductions are available only to taxpayers whose AGI falls below a certain threshold.

After taking all deductions and credits into account, you arrive at your taxable income, which is the amount of income that is subject to tax at the applicable tax rates. The tax rates depend on your filing status, such as single or married filing jointly, and your taxable income level.

Sources of Taxable Income

The IRS recognizes several types of taxable income, including :

1) Earned Income : 
This includes wages, salaries, tips, bonuses, and commissions earned from employment.

2) Business Income : 
Income earned from owning and operating a business, including self-employment income.

3) Rental Income : 
Income earned from renting out property, such as a house, apartment, or commercial space.

4) Investment Income : 
Income earned from investments such as dividends, interest, capital gains, and rental properties.

5) Retirement Income : 
Income earned from pensions, annuities, and withdrawals from retirement accounts such as 401(k)s and IRAs.

6) Gambling Winnings : 
Income earned from gambling activities, including casino winnings, lottery prizes, and online gambling.

7) Alimony and Child Support : 
Income received from court-ordered spousal support and child support.

8) Social Security Benefits : 
Income received from Social Security benefits.

9) Royalties : 
Income earned from the use of a patent, copyright, or other intellectual property.

10) Capital Gains : 
This includes profits earned from selling capital assets, such as stocks, real estate, and other investments.

11) Unemployment Benefits : 
This includes income received from unemployment benefits.

12) Fringe Benefits :
Certain fringe benefits, such as the personal use of a company car or housing allowance.

13) Bartering income :
Where goods or services are exchanged for other goods or services.

14) Forgiveness of Debt :
Forgiveness of debt, such as in the case of a loan or credit card debt that is cancelled.

15) Digital Currencies : 
These alternative currency-related activities are regarded as taxable income. Anything involving the purchase, exchange, or investment of digital currencies like Bitcoin must be declare.

These are just some of the most common sources of taxable income. It's important to note that not all income is taxable, and some types of income may be subject to different tax rules and rates.

How to Calculate Taxable Income ?

Calculating taxable income involves several steps :

1) Calculate Gross Income : 
Add up all sources of income, including wages, salaries, tips, bonuses, interest, dividends, capital gains, rental income, business income, and any other sources of income.

2) Subtract Adjustments : 
Adjustments, also known as above-the-line deductions, are expenses that can be deducted from gross income to arrive at adjusted gross income (AGI). Examples include contributions to a retirement account, student loan interest, and health savings account (HSA) contributions.

3) Subtract Standard Deduction or Itemized Deductions : 
Taxpayers can choose to take the standard deduction or itemize their deductions. The standard deduction is a set amount based on filing status and is adjusted each year for inflation. Itemized deductions include things like mortgage interest, state and local taxes, charitable contributions, and medical expenses.

4) Subtract Personal Exemptions : 
Taxpayers can claim a personal exemption for themselves, their spouse, and any dependents they claim on their tax return.

5) Calculate Taxable Income :
The remaining amount after these deductions is the taxable income. The tax liability is then calculated based on the applicable tax rates and tax brackets.

It's important to note that tax laws and rules can change, and there may be additional deductions or credits that can further reduce your tax liability. The certain types of income may be exempt from taxation (Nontaxable income), such as gifts, inheritances, and certain types of insurance proceeds. Additionally, certain deductions and credits may not be available to all taxpayers. 

Therefore, it is important to consult with a tax professional or use tax preparation software to ensure that you are accurately calculating your taxable income and paying the appropriate amount of tax.

How Can I Lower My Taxable Income ?

There are several ways to lower your taxable income, which can ultimately result in a lower tax bill. Here are some strategies you can consider :

1) Contribute to retirement accounts : 
Contributions to traditional IRAs and 401(k) plans are tax-deductible, which can lower your taxable income. For the tax year 2022, you can contribute up to $19,500 to a 401(k) plan and up to $6,000 to an IRA.

2) Claim deductions : 
You can claim deductions for certain expenses, such as mortgage interest, charitable donations, and state and local taxes. These deductions can reduce your taxable income.

3) Take advantage of tax credits : 
Tax credits can also reduce your tax bill. For example, you may be eligible for the Earned Income Tax Credit if you have low to moderate income, or the Child Tax Credit if you have dependent children.

4) Maximize your healthcare spending : 
If you have a high deductible health plan (HDHP), you may be eligible to contribute to a Health Savings Account (HSA). Contributions to an HSA are tax-deductible and withdrawals for eligible healthcare expenses are tax-free.

5) Consider tax-loss harvesting : 
If you have investments that have lost value, you may be able to sell them at a loss to offset capital gains and reduce your taxable income.

It's important to note that these strategies may not be appropriate for everyone, and you should consult a tax professional to determine what is best for your specific situation.

Frequently Asked Questions

What is the difference between gross income and taxable income?
Gross income is the total amount of income earned, while taxable income is the portion of gross income that is subject to income tax after all allowable deductions and exemptions have been taken into account.

Is all income taxable?
Not all income is taxable. For example, some types of income, such as gifts and inheritances, are not subject to income tax. However, most types of income are taxable.

How do I know which deductions and exemptions to claim?
The IRS provides guidance on allowable deductions and exemptions. Tax preparation software and tax professionals can also assist in determining which deductions and exemptions you are eligible for.

Can I claim deductions and exemptions if I take the standard deduction?
No, if you choose to take the standard deduction, you cannot also claim itemized deductions or personal exemptions.

How do I know what tax bracket I am in?
Tax brackets are determined based on taxable income and filing status. The IRS provides a tax table and tax brackets each year. Tax preparation software and tax professionals can also assist in determining your tax bracket.

What happens if I don't report all of my income?
Failing to report all income is considered tax evasion and is illegal. If you are caught not reporting all income, you may face penalties and interest charges, as well as possible criminal charges. It's important to report all income to avoid these consequences.

Can I reduce my taxable income by making contributions to retirement accounts?
Yes, contributions to retirement accounts such as 401(k)s, IRAs, and HSAs can reduce taxable income, as these contributions are considered pre-tax. However, there are limits to how much you can contribute each year.