Taxable Income: What It Is, What Counts, and How To Calculate

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Taxable Income: What It Is, What Counts, and How To Calculate

What Is Taxable Income?

The part of your total income used to determine how much tax you owe in a given tax year is known as taxable income. It is widely defined as adjusted gross income (AGI) less allowed itemized or standard deductions. Wages, salaries, bonuses, and tips are all examples of taxable income, as are investment income and different sorts of unearned income.

Key Takeaways

  • Taxable income is the part of your total income that the IRS considers to be taxable.
  • It includes both earned and unearned income.
  • Among the sources of taxable income include compensation, companies, partnerships, and royalties.
  • Because of deductions, taxable income is often less than adjusted gross income.
  • You may start computing your taxable income by identifying your filing status and compiling all of your income-related papers.

Understanding Taxable Income

Earned and unearned income are both included in taxable income. Taxable unearned income includes canceled debts, government benefits (such as unemployment and disability payments), strike benefits, and lottery winnings. Taxable income also includes revenues from valued assets sold throughout the year, as well as dividends and interest income.

Individual tax filers have the choice of claiming the standard deduction or a list of itemized deductions when it comes to deductions, according to the IRS. Itemized deductions include mortgage interest, medical costs that surpass a certain level (7.5% of your AGI), and a variety of other expenses.

Businesses do not record their revenue as taxable income when they submit their taxes. To determine their business income, they deduct their business expenditures from their revenue. Then they deduct their deductions to determine their taxable income.

Sources of Taxable Income

Any money earned throughout the tax year is considered taxable income. Employee compensation is the most prevalent. However, there are other types of income that are taxed.

Employee Compensation

As previously stated, this is the most prevalent kind of taxable income. This is provided by your employer in the form of salary and wages, tips, bonuses, and fees. The income is reported to you on your W-2, which is sent to you by the firm. This form also contains any appropriate taxable income deductions, such as income tax, Social Security, Medicare, and 401(k) contributions.

People who offer child care in their own homes or elsewhere must include the amount they receive as taxable income, according to the IRS. This law also applies to any money you get as a result of babysitting.

You must include the value of any fringe benefits you get as a director, partner, or via your company. On its website, the IRS provides a comprehensive list of what is taxed and what is not.

Income From Business and Investments

You must declare any money earned from specific kinds of business and investment activity. This includes any rental revenue from properties that you own. It makes no difference whether the rental activity you get is the outcome of a business or if you earn it for profit. Remember that you may be able to report the rental expenditures, which may offset the money you get.

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Income from Partnerships

Partnership entities are not taxed by the IRS, but all revenue, deductions, and losses derived from them are passed through to individual partners. As a result, the partnership pays no taxes. You must report any pass-throughs on your yearly tax return if you are a partner. This must happen even if the pass-through does not directly relate to you.

Income from S Corporations

This kind of company, like a partnership, does not pay income tax on profits. This is distributed to shareholders in proportion to their ownership holding in the S company. Earnings, losses, and deductions are recorded on your personal income tax return if you are a shareholder.

Other Sources

  • Bartering is the exchange of products and services rather than currency. So, if you repair someone’s electrical system and they compensate you with a comparable service (like fixing their plumbing) rather than cash, the value of that service is taxable income.
  • Digital Currencies: Activities involving these alternative currencies are taxable revenue. You must report any transactions involving the sale, exchange, or investment in digital currencies such as Bitcoin.
  • Royalties: You must also disclose royalties earned on intellectual property (copyrights, patents, trademarks, etc.) and oil, gas, and mineral assets as taxable income.

How to Calculate Taxable Income

Here’s a step-by-step guide to calculating taxable income.

Step 1: Determine Your Filing Status

To establish your filing status for an individual tax return, you must first identify your taxable income. Provided you are unmarried, you may file your taxes as a single filer or as head of household if you pay more than half of the support and housing expenditures for a qualified individual (HOH).

If you are married, you should probably file as married filing jointly. However, there are certain restricted circumstances in which filing as married filing separately may make sense.

Step 2: Gather Documents for all Sources of Income

Once you’ve determined your filing status, you’ll need to collect documentation for all sources of income for yourself, your spouse (if applicable), and any dependents (if applicable).Your gross income is the sum of all of these sources of revenue. The most typical tax forms that you will need to compute your gross income are listed below.

  • Form W-2 reflects the money you received as an employee via services rendered.
  • You will require a Form 1099-NEC if you performed a contract job or a side gig (nonemployee compensation).When the sums are larger than $600, it reflects money obtained while working for a non-employer person or business.
  • Form 1099-MISC discloses monies received (in excess of $600) from other sources of income, such as rent, prizes, fishing boat revenues, or crop insurance payments.
  • If you earned more than $10 in interest during the tax year, your financial institution will send you a Form 1099-INT.

Step 3: Calculate Your Adjusted Gross Income (AGI)

The next step is to compute your AGI. Your adjusted gross income (AGI) is the result of some “above-the-line” changes to your gross income, such as contributions to a qualified individual retirement account (IRA), student loan interest, and certain education expenditures.

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These are known as “above the line” deductions because they lower your income before you take any permitted itemized or standard deductions.

Step 4: Calculate Your Deductions (Standard or Itemized)

The next step is to compute your deductions. As previously stated, you have the option of taking the standard deduction or itemizing your deductions.

The standard deduction is a fixed amount that taxpayers may claim if they do not have enough itemized deductions. Individual tax filers in 2021 may take a standard deduction of $12,550 ($12,950 in 2022) or $18,800 ($19,400 in 2022) if they are heads of households. The standard deduction for married couples filing jointly is $25,100 ($25,900 in 2022).

If you want to itemize your taxes rather than taking the standard deduction, the following documents are often required:

  • Property taxes and mortgage interest have already been paid. This is usually found on a Form 1098, Mortgage Interest Statement, which you’ll get from your mortgage lender. If you do not have a mortgage or an escrow account to pay your property taxes, you must maintain a separate record of your property tax payments.
  • State and municipal taxes have been paid. If you work for an employer, this is on your W-2 form. If you work as an independent contractor, you must keep track of the estimated taxes you paid quarterly during the year.
  • Donations to charity Charitable contributions are deductible expenses, but the amount you may claim is usually restricted to a percentage of your AGI.
  • Educational costs. Remember that if you use a student loan to pay for eligible higher-education expenditures, you must claim them in the year the expenses are incurred, not in the year the loan profits are received or returned.
  • Unpaid medical expenses You may deduct unreimbursed medical costs that exceed 7.5% of your AGI (the threshold in any regular tax year is normally between 7.5% and 10% of AGI).

Owners of sole proprietorships, partnerships, S corporations, and certain trusts and estates may qualify for a qualifying business income (QBI) deduction, which enables eligible taxpayers to deduct up to 20% of QBI, REIT dividends, and qualified publicly traded partnership (PTP) income. If you operate as an independent contractor, your job will almost certainly be eligible for this particular deduction.

Step 5: Calculate Taxable Income

To finish computing your taxable income, take your AGI (as computed previously) and remove any available 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.

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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 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?

Adding together all sources of income, omitting nontaxable items, and deducting credits and deductions yields taxable income.

What Is Nontaxable Income?

Nontaxable income includes revenues from a religious or philanthropic organization that are then returned to the organization. Another example is an employee accomplishment award, if certain criteria are satisfied. If you lose someone and get a life insurance payout, it is also nontaxable income (although it may subject you to an estate tax).

How Do I Lower My Taxable Income?

Ending the year with taxable income may place you in a higher tax bracket, resulting in a larger tax burden. Most individuals reduce this sum by using the standard deduction when filing their taxes. If you itemize, be careful to include every potential deduction. However, there are strategies to reduce your taxable income before you file. Contributing to a 401(k) or individual retirement account, or putting money away in a flexible spending or health savings account.

The Bottom Line

Income is any monetary remuneration for delivering a service. Money is, of course, the most usual form. However, most individuals are unaware that there are alternative types of income, such as property and in-kind services. And they’re all taxed. Knowing what to include may make tax preparation simple and painless. To prevent problems, utilize the information and recommendations provided above to appropriately calculate and disclose your taxable income.

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