Taxable IncomeDefined along with Examples

Written By:
Lisa Borga

What is Taxable Income?

Taxable income refers to the part of gross income for an individual or corporation which is subject to tax after deductions and exemptions are accounted upon.

This typically means that taxable income will be less than gross income.

Taxable income includes virtually all income that a taxpayer earns in a year, such as wages and tips, as well as unearned income, investment income, and fringe benefits.

Taxable Income Explained

The Internal Revenue Service (IRS) classifies all income as taxable income unless it is explicitly exempted.

This means that taxable income is a highly broad category that includes earned and unearned income as well as income from investments.

Common sources of income that are typically taxable include:

• Business earnings
• Salaries or wages
• Bonuses, tips, or commissions
• Capital gains
• Gambling or lottery winnings
• Interest and dividends
• Unemployment compensation
• Strike benefits

Most commonly, taxable income may come in the form of cash; however, it is important to keep in mind that they do not have to.

Taxable income can include property that is received as well as services.

Bartering or trading property is taxable, as well as services that are received.

For example, if a plumber and an electrician decided to exchange their services and perform work on each other’s houses, they would be required to declare the value of the services each received as income.

However, gross income is not necessarily taxable income.

Instead, taxpayers must calculate their taxable income by making any “above the line adjustments,” which will determine the adjusted gross income (AGI) that, in turn, will be used to find taxable income.

For individuals, the IRS provides the option to claim a standard deduction or to itemize their deductions in order to arrive at their total taxable income.

In order to choose between itemizing or choosing the standard deduction, it is generally best to choose whichever will result in the lower tax payment.

Deductions that can be itemized include a wide array of expenses, including certain medical payments within a range, mortgage interest, and charitable donations, among many others.

For businesses, revenue is not directly reported either, and instead, they will first subtract business expenses in order to find their income.

From here, they will similarly account for any applicable deductions in order to find their taxable income.

Once the taxable income is found, taxpayers may use this number as well as their filing status to find their applicable tax brackets and corresponding marginal tax rate.

Computing Your Taxable Income

Here is how to compute your taxable income.

Choose Your Filing Status

Before you are able to do your taxes, you’ll need to figure out what your filing status is.

There are five different tax filing statuses to choose from.

We will list these below and explain them to help you determine your status:

• Single: This tax status is for unmarried taxpayers who do not qualify for any of the other filing statuses.
• Head of Household: The head of household status is for single taxpayers who are paying for at least half of the costs of housing and supporting one or more other eligible people.
• Married Filing Separately: This filing status is used by married taxpayers who choose to be responsible for only their own taxes rather than being jointly liable.
• Married Filing Jointly: This is the most common filing staus for married taxpayers. Married couples using this status report all of their income, tax credits, and tax deductions on the same return.
• Qualified Widow or Widower: This status is for those taxpayers whose spouse has recently died. It is generally not used in the year the spouse died. The married filing jointly status is generally used in the year the spouse died if the married couple would have qualified for the status. However, the qualified widow or widower filing status can be used for the following two years if the widow or widower has not remarried and has a dependent child for which they pay at least half of the housing costs.

Make Sure You Have the Necessary Tax Documents

Once you have determined what your filing status will be, you need to get together all of the tax documents showing the income for you and anyone else that will be on your tax return.

Make sure you consider all of your sources of income. Here are some potential sources of income.

• Employment Income: For most people, this will include income reported on their W-2, which shows the income they received as an employee.
• Non-employee Compensation: This would be reported on Form 1099-NEC (non-employee compensation). This form reports income for work that was performed as a non-employee if it amounts to more than $600. It could also include non-employee compensation for contract work or a side gig, which is increasingly common.
• Miscellaneous Income: Some people may also have miscellaneous income from sources, such as prizes, crop insurance payments, or rents. This would be reported on Form 1099-MISC.
• Constructively-Received Income: It is important to remember that you are generally taxed on constructively-received income, meaning income that is available to you. You don’t have to have possession of it. For example, if you received a check but you have not cashed it, the check is still income because it is available to you. Constructively-received income may also include income received by a third party for you and income that you have been paid for future services.
• Partnership Income: Partnerships are generally not taxable entities. Instead, each partner’s share of the income will pass through to them and be recorded on their personal income tax return. All income must be reported, whether it is distributed or not.
• S-Corporation Income: Like a partnership, S corporations are not taxable entities. The income from the corporation will pass through to the shareholder based on their percentage of ownership and be reported on their personal income tax return.
• Royalties: Royalties may be earned from patents, copyrights, as well as oil, gas, and mineral properties. Royalties are taxed as ordinary income.
• Interest: If you have earned at least $10 in interest, you will receive Form 1099-INT, which you will report on your taxes.

Calculate Your Adjusted Gross Income

Now, you need to calculate your AGI.

Your adjusted gross income will include income from wages, dividends, capital gains, business income, retirement distributions along with other income.

You may also make some adjustments, including educator expenses, student loan interest, alimony payments, or contributions to a retirement account.

These items are called “above the line” items due to the fact that they are subtracted from your income before determining your adjusted gross income.

Decide What Your Tax Deductions Are 

Now, you’ll need to determine what your deductions are.

You’ll need to decide if you are going to take the standard deduction or itemize your deductions.

If you choose to take the standard deduction, it is a set amount.

For the 2021 tax year, the standard deduction is $12,550 for single taxpayers, $18,800 for heads of household, and $25,100 for married couples filing jointly.

This will change to $12,950 for single taxpayers, $19,400 for heads of household, and $25,900 for married couples filing jointly for the 2022 tax year.

You may want to itemize deductions if you believe it would result in a larger total deduction than the standard deduction.

Here are some commonly deducted items.

• Mortgage Interest and Property Taxes: You will find this amount on a Mortgage Interest Statement (Form 1098), which should be provided by your mortgage lender. For those homeowners that do not have a mortgage or an escrow account, it is important to keep track of the property tax payments you make.
• Local and State Taxes: If you work for an employer, this amount can be found on your W-2 form. Whereas independent contractors will need to record any estimated tax payments they make during the year.
• Medical Bills: You can deduct some of your unreimbursed medical expenses. However, the expenses must be greater than 7.5% of your AGI. You will calculate the amount on Schedule A of Form 1040.
• Education Costs: You may be able to deduct some higher education costs. The two most common credits are the American Opportunity Credit and the Lifetime Learning Credit. However, there are limits on these credits. For example, both of these credits are reduced and eventually phased out for people with high incomes.
• Donations to Charity: Donations that you make to charity are deductible. Although, the deduction is limited in most years to a certain percentage of your adjustable gross income.
• Qualified Business Income (QBI) Deduction: This deduction is for taxpayers who are self-employed or own a small business. These taxpayers may be able to deduct up to 20% of their qualified business income. Generally, the deduction for 2021 is limited to those earning up to $164,900 for single taxpayers and $329,800 for married taxpayers filing jointly.

Calculate Your Taxable Income

The last step you will need to take to calculate your taxable income is to subtract any relevant deductions from your adjusted gross income, which you calculated earlier.

If you have had any student loans forgiven, this amount will not be taxable if the forgiveness occurs from January 1, 2021, until December 31, 2025, as a part of the American Rescue Plan.

The Difference Between Taxable and Nontaxable Income

The Internal Revenue Service classifies most income as taxable income.

However, there are a few types of income that are non-taxable.

One example of non-taxable income is income earned from a religious organization that is then returned to the organization due to a vow of poverty or other similar reason.

Another type of non-taxable income is employee awards, although there are certain conditions that must be met.

Additionally, if you are the beneficiary of a life insurance policy, this income is also non-taxable.

Not all tax agencies have the same definition of non-taxable and taxable income.

The rules can vary from country to country.

Unearned Income

Unearned income consists of income that comes from sources other than employment.

Some examples of unearned income are rental income, interest, capital gains, and dividends.

Some government benefits, such as disability benefits and unemployment benefits or loans that have been forgiven, are forms of unearned income.

Lottery and casino winnings are also considered unearned income.

Calculating Taxable Income

Your taxable income can be calculated by computing the sum of any income you have, not including non-taxable income, then subtracting any deductions and credits.

Non-Taxable Income

There are several types of non-taxable income, such as earnings from a charitable or religious institution, that are given back to the institution.

Awards that a person earns at work may also be non-taxable.

Although, there are certain conditions that must be met.

Life insurance benefits you receive when someone dies are also non-taxable income, but you may be required to pay estate tax.

Key Takeaways

• Taxable income is the portion of a taxpayer’s gross income which is used to calculate how much an individual owes the government in taxes.
• Because deductions and exemptions reduce the base upon which taxpayers owe money, it is typically less than gross income.