Taxable income is the amount of money, in earned income and unearned income, that creates a potential tax liability.
Earned taxable income is any income you receive for work and for other services provided. Any wages, tips, and fees you receive is deemed by the IRS as "earned income."
What, exactly, is unearned income?
What is Unearned Income?
Unearned income is money you get without actually directly working for it. The term actually covers a great deal of ground and includes the following categories:
- Unemployment benefits and other federal and state financial benefits.
- Canceled debts.
- Lottery winnings.
- Profits earned by assets sold (like a car or an asset sold for a profit on eBay or any online sales site.)
- Alimony payments and child support.
- Social Security and Medicare benefits paid by your employer.
- Severance pay.
- Rental income from personal property.
- Capital gains and losses when investing.
- Stock dividends.
- Bonuses and rewards (like trips paid for by your employer.)
While taxable income covers the amount of money, in gross income terms, owed to the government, the IRS does consider some forms of income to be nontaxable.
It's worth noting, though, that most forms of non-taxable income, while not taxable, still need to be listed on your income tax return.
Here are some examples of non-taxable income:
- Cash gifts and inheritances.
- Cash rebates from retailers and businesses.
- Welfare income.
- Damages from a physical injury, illness or disability.
- Child support payments.
- Hotel and restaurant (like meals) services incurred when on the job.
There's yet another category of income that may or may not be considered taxable by the IRS (for example, the income may be granted as an exclusion by the IRS). It's a good idea to talk with a professional accountant to see if any of the following potential sources of income are tax exempt:
- Cost of living adjustments (like under Social Security);
- Noncash income;
- Collegiate scholarships;
- Life insurance;
- State and local tax refunds or credits.
Deductions and Taxable Income
Uncle Sam provides a substantial break on taxable income in the form of the standard deduction on U.S. individual and spousal tax forms. It offers more tax breaks in the form of itemized deductions, which require you to record all expenses incurred that you wish to use on your tax returns.
Basically, taxpayers can claim either the standard deduction when filing taxes, or they can itemize their qualifying individual deductions. The standard deduction cuts your taxable income by a specific amount ($12,200 for the 2019 tax year for single filers, $18,350 for heads of household and $24,200 for married couples filing jointly). Itemized deductions are comprised of individual deductions based on potential eligible expenses. It's up to the taxpayer to decide which deduction to claim, so it's important to know which deduction lowers your tax burden most.
It's also worth noting that the new tax bill, passed in December 2017, changes the standard deduction levels.
Starting in 2018, the standard deduction changed to:
- $24,000 for married filing jointly or surviving spouse.
- $18,000 for head of household.
- $12,000 for married filing separate or any single filer.
And since then, the standard deduction has increased incrementally each year and continues to do so; while the standard deduction for single filers is $12,200 for the 2019 tax year, it will be $12,400 for the 2020 tax year.
For Americans 65-and-over get a big tax break, too. In addition to getting the standard deduction, individual tax filers who are 65-or-over can claim an additional $1,650 deduction on their taxes, and married filers over 65 can claim an extra $2,600 ($1,300 if married, filing jointly when only one spouse is 65 or older).
In general, the standard deduction is preferable if you don't have a long list of itemized deductions; it keeps you from having to record expenses, hang on to receipts and keep a ledger on itemized expenses.
Another way to slash your taxable income is by using itemized deductions.
The savings can really add up in doing so. If you're a taxpayer in the 15% tax bracket, every $1,000 listed as itemized deductions on your tax return saved you $150, according to H&R Block. So $5,000 in itemized deductions can save you $750 off your tax bill.
All itemized deductions for individual and married taxpayers should be included on IRS Tax Form 1040, in Schedule A. Itemized tax deductions are not allowed on IRS Tax Form 1040A or 1040EZ -- only the standard deduction can be taken on those forms.
Itemized deductions cover a wide array of expenses incurred over the course of a year that would otherwise be deemed as taxable by the IRS. Typical itemized deductions include:
- Mortgage interest;
- Health care expenses;
- Property taxes;
- Charitable expenses;
- Investment interest expense;
- Tax preparation fees;
- State and local taxes.
If your list of itemized deductions adds up to more in tax savings than your standard deduction, then itemizing is the way to go. Just be sure to save receipts and record your expenses on a regular basis, and store them safely in the event the IRS asks about an itemized deduction.
The formula for figuring out your estimated itemized deductions is easy -- list your expenses and count them up. Then, subtract your total deductions from your taxable income to calculate your itemized deductions.
How to Calculate Taxable Income
There's no hard and fast formula for calculating taxable income, as your total taxable income depends on your tax deductions, filing status and the standard deduction. Just know that your goal going in is to take the maximum amount of deductions possible to lower your tax bill.
Once you have your calculator in place, take these steps to calculate your taxable income:
- Figure out your total taxable income for the year, including both earned and unearned income.
- Calculate your adjusted gross income. Your adjusted gross income is your gross annual income, with any adjustments (or above the line tax deductions) subtracted.
- Subtract any standard or itemized tax deductions from your adjusted gross income.
- Subtract any tax exemptions you are entitled to, like a dependent exemption.
- Once you've subtracted any tax form adjustments, deductions, and exemptions from your gross income, you've arrived at your taxable income figure.