How Do You Calculate Taxable Income?

January 26, 2023

Taxable income includes more than your usual wages and salary. Don't forget any other sources of income when calculating income for tax filing.

Taxable income refers to the amount of your income that is subject to being taxed. The amount of income that is subject to being taxed depends on a few factors, like deductions, exemptions, and credits. 

By learning how to calculate this number you will better understand your tax liability and how to estimate how much you need to pay in taxes each year.

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What is Taxable Income?

what is taxable income definition

Taxable income is the amount of a taxpayer's yearly earnings that are subject to tax, or tax liable. Another word for this is adjusted gross income (AGI), because this is your amount of income adjusted to only include the amount that is taxable. 

Things like tax exemptions, credits, standard deductions, itemized deductions, or adjustments can make some part of your total annual income free from tax obligations. 

This is why we file an income tax return each year by filling out 1040 forms with lots of financial information. This information will help the IRS determine how much of your income is taxable vs how much is tax deductible.

Then, how much you owe in taxes will be determined from this number, rather than your total income. 

Individual Income Tax

Individual income tax, also known as personal income tax, is the tax applied to an individual person's income. These rates may be different from a tax applied to business income.

Adjusted gross income could also include income like your paycheck, freelance earnings, rental income from real estate properties you own, short- and long-term capital gains, capital assets, and more. 

Business Income

Business Income includes earnings from the sales of products and services. If you own or operate a small business, you may have business income that is subject to business taxes. This could also include self-employment income.

Federal Income Tax

Federal income tax is the income tax that everyone pays to the federal government. Depending on your state and local government, there may also be state and local government income taxes to pay. 

What is Nontaxable Income?

Nontaxable income includes any earnings that are not subject to income taxes, usually due to some kind of deduction or exemption. 

Earnings that are considered nontaxable by the IRS include: 

  • Inheritances 
  • Gifts
  • Bequests
  • Cash rebates on items purchased from a retailer, manufacturer, or dealer
  • Alimony payments (for divorces that finalized after 2018)
  • Child support payments
  • Some healthcare benefits
  • Qualifying adoption reimbursements 
  • Welfare payments 
  • Life insurance payments 

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Common Types of Taxable Income

common types of taxable income

Common types of taxable income include earnings from your paycheck, freelance work, and small business. Many forms of income will be subject to taxes. The following forms of income is subject to income tax and is included in calculating your AGI. 

Paycheck Income

Paycheck income includes earnings you receive by providing your personal services to an employer. 

Freelance Income 

Freelance income includes earnings you receive for doing freelance work for clients, individuals, or companies. 

Small Business Income

Small business income includes earnings you receive from a business you own or operate. 

Fringe Benefits

Fringe benefits include any benefits or compensation you receive for providing your personal services to a client or employer.

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Investment Income

Investment income includes earnings you receive from successful investments. 

Royalties Income 

Royalties include income from copyrights, patents, and oil, gas, and mineral properties. 

Virtual Currency

Virtual or digital currency includes things like bitcoin and do count as taxable money. 

Bartering Earnings

Bartering includes earnings from the exchange of goods and services, often without a cash exchange. For example, exchanging plumbing services for dental services is considered bartering and is included in calculating AGI. 

Capital Gains

Capital gains include profits from selling investments. When you sell stocks, bonds, or real estate you make investment profit called capital gains, and is included in your overall AGI. 

Rental Income

Rental income includes earnings from receiving rent payments from tenants. This money is also used to calculate your AGI. 

How to Calculate Taxable Income

how to calculate taxable income

Taxable income is calculated by applying an income tax rate to a tax filer's total taxable income, otherwise known as their adjusted gross income (AGI).

The money you earn throughout the year is subject to federal, state, and local taxes. Things like your filing status and whether you're married filing jointly, separately, or a single filer will then impact the tax rate applied to your AGI. 

Step 1: Add All Sources of Income Together

Make sure you don't forget anything when adding this number together. If you have any other means of earning money throughout the year, then you'll want to include those too. 

Step 2: Add All Deductions Together 

Once you have all your sources of income added together, it's time to look at potential deductions and which ones apply to you.

These tax deductions include forms of nontaxable income. After you've added together all the deductions you qualify for, you'll want to subtract these deductions from your total income. 

Common Tax Deduction Examples:

  • Health insurance premiums 
  • Charitable donations 
  • Childcare expenses 
  • Student loan interest payments 
  • Some business expenses 
  • and more

Step 3: Subtract Deductions from Income

Once you have your total income and total deductions, subtract your deductions from your income. The number you'll be left with is your AGI.

This is sometimes referred to as your adjusted gross income, because it is your gross income (aka, your total income) adjusted with the subtraction of relevant tax deductions. 

How to Reduce Taxable Income

how to reduce taxable income

To reduce your taxable income, you want to apply all the tax deductions you can. Basically, how much you pay in taxes increases as your income increases.

The best way to reduce the amount of income that is taxable is to take any and all tax deductions and credits you can.

These will reduce your AGI and help you pay less in taxes overall. Using a tax professional can help you go over all your available tax deductions, credits, and itemizations so you don't miss out on any tax savings. 

There are tax breaks for homeowners that could apply to you if you own a home. There are child tax credits for if you have a child or qualifying dependent under your care at home. 

There are also many deductions you can itemize if you have qualifying business expenses, or if you have property tax expenses that the federal government lets you deduct. 

Is Social Security Combined Income Taxable?

Social security is a unique form of income that is a part of a government retirement plan.

Taxes go toward this Social Security fund and then qualifying retiring individuals can receive Social Security benefits in their retirement. 

This Social Security income is treated just like earned income by the IRS and is taxed just like earned income. 

Is Per Diem Taxable?

What is per diem? A per diem is a type of allowance a company or organization might give an employee for certain expenses.

For example, if your company gives you a company card to pay for gas, then that money is called per diem. 

Per diem is not considered an additional wage or income by the IRS. Therefore, per diems are not taxed.

But, if this per diem, employee allowance doesn't meet the federal requirements for per diems, then this money is considered an extra wage and is subject to taxes. 

Per Diem Requirements

  • Per diem allowances are greater than the current federal per diem rate 
  • The per diem recipient did not file an expense report to the employer

Is Net Pay Taxable?

Net income is the income you have left over after taxes while taxable income is the income you have that is subject to being taxed.

Net income is your take-home pay, the amount of money you get to take home in your paychecks after an employer has already deducted payroll taxes.

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