What is Taxable Income?
Taxable income is the share of total income (aka gross income) in one year that is used to calculate the taxes owed to the government.
Taxable income is the part of your income that’s used to figure out how much you owe the government (federal, state, and/or local) in taxes. It’s usually calculated by taking the total income (aka gross income) you earn in a tax year and subtracting any adjustments, deductions, or exemptions allowed by the government. Most types of income are considered taxable — Everything from hourly wages to annual salaries, fringe benefits, bonuses, interest accrued on your savings, and any investment dividends. Certain types of income are considered non-taxable, such as life insurance proceeds, or income earned by a charitable nonprofit. The term “taxable income” may also refer to any type of income that is eligible to be taxed.
Calculating your taxable income can be a pretty complicated process, so it helps to break it down into steps. While the process varies slightly depending on the type of tax you’re filing (federal or state), the main steps are pretty similar. Here’s a general example:
First, you need to know your gross income. Let’s say you have a full-time job that pays an annual salary of $75,000. In your free time, you also like to collect and sell rare vinyl records. When tax season rolls around, you receive a W-2 from your employer showing your annual salary. That year you also made a $8,000 profit from your records sales. Between your salary and side hustle, you earned a gross income of $83,000.
Once you know your gross income, you then subtract any qualifying adjustments. Adjustments are specific expenses in a given year — Like school tuition or certain retirement contributions — that the government says you can deduct from your gross income to lower your overall tax liability. So let’s say that in the same year you earned $83,000, you also paid $5,000 in school tuition to take business classes at your local community college. The tuition is an example of an adjustment allowed by the government. If the tuition was your only adjustment that year, then you’d be left with an adjusted gross income (AGI) of $78,000.
Next you determine which deductions you can take out of your AGI. Deductions are similar to adjustments in that they also lower your overall tax liability. You typically have to choose one of two kinds of deductions: standard or itemized. A standard deduction is a flat amount set by the Internal Revenue Service (IRS) each year. Each taxpayer’s standard deduction can vary depending on their tax filing status. If you’re a single taxpayer (as opposed to a married couple filing together), the government allows you a standard deduction of $12,400 (for tax year 2020). In this example, that would leave you with a taxable income of $65,600.
Alternatively, let’s say that you have qualifying medical expenses, interest on student loans, and retirement contributions that added up to $14,400. These are examples of itemized deductions. Taken out of your AGI, you’d be left with a taxable income of $63,800. In other words, your taxable income would be $2,000 lower if you choose to take itemized deductions instead of the standard deduction.
Taxable income is like the discounted price of a sweater…
The original price of the sweater is marked down by the store. On top of that, you have a store coupon you earned by making a qualifying number of purchases. Once you apply the store’s discount and your coupon, you end up paying half of the sweater’s original price, plus the sales tax. Taxable income is like that final sale price — you’re taxed on the amount that’s left after taking out certain “discounts” allowed by the government.
The two often go hand in hand, but there are important differences. Gross income is the sum of all income you earn in a given tax year, including hourly wages, annual salaries, fringe benefits, bonuses, and interest earned on investments. Taxable income is the amount of your gross income left after taking out any adjustments, deductions, or exemptions that are allowed by law. It’s used to figure out how much you owe the government (federal, state, and/or local) in taxes. Think of gross income as a whole apple pie; taxable income is the chunk of the pie that’s left after you take out specific slices — Adjustments, deductions, and exemptions.
Salaries and wages are two of the most common types of taxable income, but there are many more types of income that the IRS treats as taxable. Here are some examples:
If you receive any of the above, you may need to report them as part of your gross income on your tax forms.
Adjustments and deductions are similar in that both lower your overall tax liability. In other words, the larger the amount of adjustments and deductions taken out of your gross income, the lower your taxable income. But there are a few distinctions between adjustments and deductions worth noting.
Adjustments are specific expenses in a given year — Like school tuition or certain retirement contributions — that the government says you can deduct from your gross income to determine your adjustable gross income (AGI).
Deductions are another set of expenses that can be taken out of your AGI to further lower your tax liability. There are two ways to apply deductions (standard and itemized) and each taxpayer must choose one of the two.
A standard deduction is a flat amount set by the Internal Revenue Service (IRS) each year. Each taxpayer’s standard deduction can vary depending on their tax filing status. If you’re a single taxpayer or a married person filing individually in 2020 (as opposed to a married couple filing together), the government allows you a standard deduction of $12,400.
Itemized deductions, on the other hand, encompass a pretty broad range of expenses, like mileage, home office items, interest on student loans, property taxes, medical expenses, and retirement contributions. This is often regarded as the more complicated option, largely because (as the name implies) you have to itemize each deduction you take and follow specific rules on what to deduct and how much. (You also have to keep corresponding receipts.) But the effort can be worthwhile for some taxpayers, especially if their itemized deductions add up to exceed their standard deduction.
Your tax credits affect how much you owe in taxes, but it doesn’t directly affect your taxable income. Credits are typically removed from your tax bill after taxable income is calculated. Examples of credits include the earned income tax credit, dependent child tax credit, and adoption credit.
The 2018 tax year changes affect your taxable income in various ways, including the percentage of your income that must be paid in tax, and how some deductions are handled. For the 2018 tax year, the new tax bracket rates are 10%, 12%, 22%, 24%, 32%, 35%, and 37%, depending on your income. The income ranges in each bracket will be indexed for inflation each year.
One thing to note about income tax rules is that they’re often changing. The 2018 Tax Cuts and Jobs Act (TCJA) is the latest in a long line of changes to tax laws throughout history. Most of the individual provisions in the TCJA will expire in 2025 without further action by Congress.
2018 Tax Year Income Brackets
|Tax Rate||Taxable Income Levels - Single filers||Taxable Income Levels -Married Filing Jointly|
|10%||Up to $9,700||Up to $19,400|
|12%||$9,701 to $39,475||$19,401 to $78,950|
|22%||$39,476 to $84,200||$78,951 to $168,400|
|24%||$84,201 to $160,725||$168,401 to $321,450|
|32%||$160,726 to $204,100||$321,451 to $408,200|
|35%||$204,101 to $510,300||$408,201 to $612,350|
|37%||Over $510,300||Over $612,350|
Personal exemptions on income taxes have been eliminated for now, and standard deduction increased significantly. The personal exemption was an amount each filer could take out of their adjusted gross income (AGI) to reduce their tax liability. In the 2017 tax year, the personal exemption was $4,050, but only for those making less than certain AGI amounts. The personal exemption began phasing out at income levels of around $261,000 and was reduced to $0 for those making $384,000 (married couples filing jointly had higher income limits). To make up for the loss of personal exemptions, standard deductions were raised significantly. The goal of this change in exemptions was to reduce the number of filers who have to itemize deductions.
2018 Tax Year Standard Deductions
|Married filing jointly||$24,000|
|Qualifying widow or widower||$24,000|
|Married filing separately||$12,000|
|Head of household||$18,000|
The 2018 tax changes also affected itemized deductions. Here are some examples:
Under the 2018 changes, itemized deductions on your income tax no longer phased out if your adjusted gross income (AGI) total was too high. Medical and dental expenses now had to be more than 7.5% of AGI, instead of the previous 10%, to be deductible. This returned back to 10% for the 2019 tax year, filed in 2020.
Combined deductions for state and local income taxes, sales taxes, and property taxes are limited to $10,000 in most cases.
The rules for deducting interest on mortgages and home equity loans changed to non-deductible unless the loan in question is used to “buy, build, or substantially improve” your home.
Deductions for charitable contributions made in cash have a limit of 60% of your AGI instead of the previous 50%.
For deductions related to casualty and theft from natural disasters, the loss has to occur in a federal disaster area designated by the Federal Emergency Management Agency (FEMA).
Alimony payments on divorces after 2018 are no longer deductible.
Miscellaneous itemized deductions and moving expense deductions are suspended.
Taxable income is the amount used to determine how much money you owe to the government in taxes (before applying credits). Generally speaking, a higher taxable income means a lower tax refund. If your taxable income is higher than the sum of your tax credits and the taxes you’ve already paid (aka withheld taxes), it’s likely that you won’t get a refund. Higher withholding during the tax year can help to offset increases in taxable income at the end of the year.
Following the 2018 Tax Cuts and Jobs Act (TCJA), the IRS strongly recommends that people update their withholding through their employers based on the tax law changes. According to the IRS, the 2018 changes made updating withholding is especially important for those who:
To help taxpayers determine if they have the right withholding set up on their W-4s — The tax form that new employees fill out to tell their employers how much tax to withhold from each paycheck — the IRS provides a withholding calculator on their website, IRS.gov.
The process of calculating your taxable income will vary slightly depending on the type of tax you are filing (usually federal or state) and the types of forms you need to fill out. Generally speaking, you’ll start by reporting all income, remove exempted income or adjustments, then apply any appropriate deductions. The amount left is your taxable income. (The example above offers a more detailed breakdown.)
Federal and state governments consider most types of income as taxable. Taxable income refers to the amount of income that’s used to determine how much you’ll pay in government taxes. It’s usually the amount of income left after subtracting any exceptions and deductible expenses. But there are certain types of income that are classified as non-taxable, or income that the government doesn’t require you to pay taxes on. Non-taxable income is usually still reported on income tax forms, but exempt from being taxed.
A few types of non-taxable income, like U.S. Veterans Administration (VA) disability benefits, do not have to be reported on tax forms in most cases. Taxable and non-taxable income designations and reporting rules may vary between federal (IRS) and state revenue departments.
According to the IRS, examples of non-taxable income include:
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