Taxable Income: What is It, How to Reduce It, and More
Unless it’s specifically exempt from tax by law, all income received during the year is taxable income for federal income tax purposes. This includes wages and other compensation from employment, self-employment income, investment income, business income, and more. However, you can subtract various tax deductions from this income when calculating taxable income for your federal income tax return.
Key Takeaways
- Your taxable income is used to determine your tax bracket and marginal tax rate, which ultimately impact how much federal income tax you owe.
- Your federal taxable income is equal to your gross income, minus any eligible tax deductions.
- Taxable income can come from various sources, including employee compensation, self-employment income, investment income, Social Security benefits, business income, and more.
- There are several ways to reduce your taxable income, such as claiming all eligible deductions, contributing to certain tax-advantaged accounts, deferring income to the following year, and using tax loss harvesting to offset capital gains with capital losses.
What is taxable income?
As you work your way through your federal income tax return, you’ll eventually end up with your taxable income. This is an important amount, since your federal taxable income is used to determine your tax bracket and marginal tax rate.
But what exactly is your taxable income? Basically, it’s your gross income, minus any tax deductions you’re eligible to claim (including either the Standard Deduction or itemized deductions).
Your gross income – and, therefore, your taxable income – generally includes all the income you receive during the tax year, unless it’s specifically exempt from tax by law. And for this purpose, income can be in the form of money, property, or services.
TurboTax Tip:
Taxable income must be reported on your federal income tax return. Exempt income, which is not taxed, still might have to be reported on your return.
Types of taxable income
Thanks to the broad definition of gross income, there’s a long list of payments, compensation, earnings, and more that are considered taxable income. While we can’t cover them all here, let’s take a look at some of the more common types of taxable income.
Employee compensation
Wages, salaries, commissions, tips, bonuses, and other forms of payment for personal services are generally included in your federal taxable income. Other forms of employee compensation – such as fringe benefits and stock options – can be added to your taxable income, too.
Self-employment income
If you work for yourself – either on a full-time basis or just as a side gig – your income from self-employment is generally taxable. However, you can deduct related expenses from that income so that only the profit from your business is taxed.
If your business loses money, you can usually deduct the loss from your taxable income. However, the deduction may be limited in some cases.
Self-employed people also have to pay self-employment taxes, which help fund the federal Social Security and Medicare programs. Self-employment taxes and income taxes are different, so you generally have to pay them both if you’re self-employed. However, when calculating your income tax for the year, you can deduct 50% of your self-employment tax from your taxable income.
Investment income
When you invest money, the earnings from your investment are often taxed. For example, if you put money in a savings account, the interest you earn is generally included in your taxable income. Withdrawals from traditional IRAs and 401(k) accounts are typically taxable, too (although withdrawals from Roth IRAs and Roth 401(k) accounts in retirement generally aren’t taxed).
If you sell stock, bonds, cryptocurrency, or other investment property, any gain from the sale is also typically included in your taxable income. If you held the property for more than one year before selling it, the gain will be taxed at the long-term capital gain tax rates, which are usually lower than the rates for other forms of
taxable income. If you have a net loss for the year from the sale of investment property, you may be able to use some of the loss to reduce the rest of your taxable income.
Dividends are usually considered taxable income as well. In some cases, they’re even taxed at the lower capital gain rates.
If your modified adjusted gross income is above a certain amount, you might also have to pay an additional 3.8% surtax on your net investment income.
Social Security benefits
If your income is high enough, a portion of your Social Security benefits will be included in your taxable income (up to either 50% or 85% of your benefits). On the other hand, if your income is low enough, you won’t have to pay tax on any of your Social Security income.
You won’t have to pay any tax on your Social Security benefits if your only income is from Social Security. However, if you have other sources of taxable income – such as from a traditional IRA, capital gains, or rental income – you’ll likely have to pay tax on at least a portion of your benefits.
Business income
In addition to self-employment income, you might have other taxable income from a business. For example, if you’re a partner in a partnership or an S corporation shareholder, the business’s income (along with any losses, deductions, and credits) passes through the business to you. You’re then required to add your proportionate share of this income to your taxable income.
Landlords generally must count the rent payments they receive as taxable income, too. The same is true for income from renting personal property, such as equipment, furniture, or vehicles. However, related expenses can often be deducted from rental income (although the deduction might be limited).
Royalties from copyrights and patents are also considered taxable income. Ditto for royalties from oil, gas, and mineral properties that you own.
Other types of taxable income
While not an all-inclusive list, here are some additional types of income that might be included in your taxable income:
- unemployment compensation
- alimony received under a pre-2019 divorce decree
- jury duty pay
- prizes and awards
- gambling winnings (including from lotteries, raffles, or sweepstakes)
- cancelled debt
- scholarships used for certain purposes (such as room and board)
- back pay (including payments from a successful lawsuit for age discrimination)
- severance pay
- union strike or lockout benefits
Again, you should generally treat any income you receive during the year as taxable income, unless there’s a law specifically exempting it from tax.
Types of nontaxable income
Now for some good news. The following types of income are generally exempt from taxation (although exceptions may apply), so you typically don't owe Uncle Sam income taxes on them:
- alimony received under a post-2018 divorce decree
- casualty insurance proceeds
- child support payments
- combat pay
- court awards or damages for personal physical injuries
- federal income tax refunds
- foster care payments
- gifts to you (although the person making the gift might owe gift taxes)
- health savings account (HSA) withdrawals used to pay medical expenses
- home sale profits (up to $250,000 for single taxpayers or $500,000 for joint filers who qualify for the exemption)
- inherited cash or property
- interest on municipal bonds issued by state or local governments
- life insurance proceeds
- rebates for items you buy (although your basis in the item is reduced by the rebate amount)
- Roth IRA or 401(k) plan distributions
- scholarships used to pay for tuition, fees, and course-related expenses
- Supplemental Security Income (SSI) benefits
- veterans' benefits
- worker's compensation payments
Again, this isn’t an all-inclusive list, so you could receive other forms of nontaxable income, too.
If you’re in doubt about whether some of your income is taxable or nontaxable, don’t guess! You can check IRS Publication 525 (which lists common types of taxable and nontaxable income) or talk to a tax professional who can tell you whether it’s taxable or not.
How to calculate taxable income
There are a few steps to follow for calculating your taxable income for the year. Remember: Your taxable income equals your gross income, minus any tax deductions.
Step 1. Determine your filing status
The first step is to determine your filing status. This is important because you need to know if you have to include your spouse’s income (for joint filers) or just your own (for all other people) in the calculation.
Your filing status might also affect your eligibility for or the amount of certain tax deductions used to lower your taxable income.
Step 2. Determine your gross income
Next, add up all your income – except nontaxable income – to determine your gross income. If you’re filing a joint return, include your spouse’s income as well.
In many cases, you’ll receive an information return showing income you received during the year. The most common example of this is the W-2 form that employers send to their employees. You might also receive a 1099 form reporting other income you received, such as:
- Form 1099-B for proceeds from stock sales or other broker transactions
- Form 1099-DIV for dividends and other distributions from investments
- Form 1099-G for unemployment compensation, state and local tax refunds, and other government payments
- Form 1099-INT for interest income
- Form 1099-K for payments from third-party payment processors or online marketplaces
- Form 1099-MISC for rents, royalties, and other miscellaneous income
- Form 1099-NEC for freelance income or other nonemployee compensation
- Form SSA-1099 for Social Security benefits
However, assuming it’s not exempt from tax, you still must include amounts received during the year in your gross income even if it’s not reported on an information return.
Step 3. Calculate your deductions
There are various tax deductions that can reduce your taxable income. Find the ones you qualify for and calculate the amount you can deduct.
Start with the deductions listed in Part II of Schedule 1 (the IRS calls them “adjustments to income”). Among other things, these include deductions for:
- alimony payments made under a pre-2019 divorce decree
- teachers’ out-of-pocket classroom expenses
- health insurance premiums for self-employed people
- HSA contributions
- IRA contributions
- moving expenses for military personnel
- self-employment tax payments (50% of tax paid)
- student loan interest payments
You can then add either the Standard Deduction or itemized deductions to the Schedule 1 deductions. You can only add one, so pick the larger amount.
Certain self-employed people and business owners can also deduct up to 20% of their qualified business income. If you qualify for this deduction, add the deductible amount to your Schedule 1 deductions and either your Standard Deduction or itemized deductions to determine your total deductions.
Step 4. Subtract your deductions from your gross income
The final step is to subtract your total deductions from your gross income. The remaining amount is your taxable income.
FAQ about taxable income
To help you better understand how your federal income tax is calculated, let’s go over a few frequently asked questions about taxable income.
Is income taxable for this year if I don’t use it until next year?
Income is generally taxable for the year you receive it as long as it's available to you – even if you don’t use it right away. For example, if you receive a paycheck in December, but don’t cash it or deposit it until January, it’s considered taxable income when you receive the check in December.
In addition, if you’re running your own business, you generally have to report advanced payments for goods, services, or other items as taxable income in the year you receive the payment. However, you can count an advanced payment as taxable income for the year you actually earn it if you use an accrual method of accounting.
Is income taxable if someone else receives it on my behalf?
Income that would otherwise be included in your taxable income is still considered your income if it’s paid to someone else on your behalf.
For example, if part of your salary is paid directly to one of your creditors, that amount is still treated as your taxable income when the creditor receives it.
How much taxable income do I have if I receive property or services?
If you receive income in the form of property or services – instead of cash – use the property’s or service’s fair market value (FMV) on the day you receive it to calculate your taxable income.
The IRS generally defines “fair market value” as the price a willing buyer would pay a willing seller for the property or services.
Can unearned income be included in taxable income?
Unearned income is generally all income other than salaries, wages, and other amounts received as pay for work actually performed (earned income). This includes taxable interest, dividends, capital gains, rents, royalties, pension income, taxable scholarships, unemployment compensation, alimony, and more.
These items – and other forms of unearned income – are included in your federal taxable income. In fact, most of the unearned income listed has already been identified as taxable income in the discussion above.
How do I lower my taxable income?
There are a number of ways to reduce your taxable income.
One way is to make sure you claim every tax deduction you can. Also, when choosing between the Standard Deduction and itemized deductions, pick the larger of the two. The more you can deduct, the more you can subtract from your gross income.
If your employer offers a traditional 401(k) plan (or a similar employer-sponsored retirement plan), you can also lower your taxable income by contributing to the plan. Whatever you put into a traditional 401(k) account won’t be included in your taxable income for the year (although contributions to a Roth 401(k) plan will be included in your taxable income). Self-employed people can also reduce their taxable income by contributing to retirement plans designed for them, such as to a SEP IRA or traditional solo 401(k) plan.
Money put into a health or dependent care flexible spending account (FSA) set up by your employer generally won’t be included in your taxable income, either. You just need to make sure you use the funds for qualified expenses. Plus, FSAs are generally "use-it-or-lose-it" accounts, which means any amount left in the account at the end of the year can’t be carried over to the next year (although your employer can offer a limited grace period or carryover amount).
If you expect to be in a lower tax bracket next year, see if you can push some taxable income into the next year. For instance, if you’re due a big end-of-the-year bonus at work, maybe your boss can wait until January to pay it. If you’re self-employed, wait until January to send invoices that are ready to go in December. This will lower your taxable income for the current year…and increase it for next year. But if your income tax rate will be lower next year, it might be worth it.
Investors might also be able to use a strategy known as “tax loss harvesting” to lower their taxable income. This involves selling poorly-performing investments to generate a capital loss. You then might be able to use the loss to offset capital gains, or even deduct up to $3,000 of it from your “ordinary” income, both of which will lower your taxable income.
A CPA, enrolled agent, or other tax professional can help you find other ways to reduce your taxable income and cut your tax bill to the bone.
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