What is taxable income?

Federal taxable income 

If you've ever glanced at your paycheck and wondered why the amount you take home isn't the same as what you earned on paper, you're not alone.

Taxable income can seem complex, but don't worry, we're going to break it down together.

Imagine taxable income as everything you earn that is subject to taxation. This includes the money you make from your job, sure. But it also includes other bits and pieces you might not think about, like interest from your savings account or money made from selling things online.

But here's the good part: not everything you earn or spend is counted against you. There are deductions and credits that can lower how much of your income is taxable.

Keep reading to learn what taxable income is, how it compares to gross income, how you can use tax rules to your advantage, and more.

What is taxable income vs gross income?

To navigate the complexities of filing your taxes effectively, it's important to understand the difference between taxable income and gross income. Here’s a breakdown of what these two terms mean:

Gross Income

Gross income is pretax income. In other words, it’s the sum of your total earnings before any taxes or deductions are taken out. This includes all sources of income, whether taxable or not, such as wages, salaries, tips, bonuses, income from investments or rentals, and any other form of compensation.

Understanding your gross income is the first step toward calculating your adjusted gross income (AGI). AGI is your gross income after pretax deductions have been made, like contributions to health savings accounts or qualified retirement accounts.

Calculating your gross income and AGI is important, because it will help you determine your tax liability, which is the amount of money you owe to the IRS.

Taxable Income

Taxable income is the portion of your income that is subject to taxes. It encompasses various sources of income, including wages, salaries, tips, bonuses, interest, dividends, capital gains, business profits, retirement distributions, and more.

Essentially, it's the amount of money you earn throughout the year that the government deems taxable. This is after accounting for any applicable deductions and adjustments, including your standard or itemized deductions and any qualified business income deductions.

What is nontaxable income?

Nontaxable income is the money you earn that you don't have to pay taxes on. Knowing what counts as nontaxable income can help you better understand your tax situation and potentially lower your tax bill. Here are some common examples:

• Gifts and inheritances: If you receive money or property as a gift or inheritance, you usually don't have to pay taxes on it.
• Life insurance payouts: If you receive a payout from a life insurance policy due to the death of the insured person, that money is typically not taxable.
• Scholarships and grants: If you're lucky enough to get financial aid for school in the form of scholarships or grants, that money is often tax-free. However, it must be used for qualified educational expenses.
• Certain benefits: Some benefits, like workers' compensation, certain veterans' benefits, and welfare benefits, are usually not taxable.
• Qualified retirement distributions: If you withdraw money from a retirement account like a Roth IRA or a Roth 401(k) after meeting certain conditions, that money could be tax-free.

How to lower taxable income

Now that we've covered what taxable income is, you might be wondering if there's a way to reduce it. The good news is, there are strategies you can use to lower your taxable income and potentially pay less in taxes. Let's explore some practical ways to do this.

Take advantage of deductions

One way to lower your taxable income is by claiming deductions. You can use deductions to reduce your taxable income by subtracting certain expenses you’ve made throughout the year. These may include mortgage interest, property taxes, medical expenses, charitable contributions, and student loan interest.

If some of your income is from a side gig or you are self-employed through other means, it’s good to know that you qualify for some of the best tax benefits the IRS offers. You can generally deduct your business expenses from the total self-employment income. This lowers both your taxable income and your self-employment taxes, ultimately lowering your taxes.

Explore tax credits

Tax credits are even better than deductions, because they reduce the amount of tax you owe dollar for dollar, rather than just lowering your taxable income. For example, let's say you qualify for a $2,000 credit. The credit will reduce the taxes you owe by $2,000, and depending on the credit, it could add to your refund, too. There are various tax credits available, including the Earned Income Tax Credit (EITC), the Child Tax Credit, and education credits. Make sure to talk with a Tax Pro to find out if you qualify for any tax credits and take advantage of them to reduce your tax bill.

Contribute to retirement accounts

One of the most effective ways to lower your taxable income is by contributing to retirement accounts, like traditional IRAs, 401(k)s, or 403(b)s. The money you contribute to these accounts is typically tax-deductible, meaning it reduces your taxable income for the year. Plus, your investments can grow tax-free until you withdraw them in retirement.

Consider flexible spending accounts (FSAs) and health savings accounts (HSAs)

If your employer offers FSAs or HSAs, consider taking advantage of these accounts to lower your taxable income. When you contribute to your FSA or HSA, you do so with pretax dollars, which reduces your taxable income. All contributions you make to HSAs are tax-deductible and can be withdrawn tax-free for eligible medical costs. Plus, all contributions made to an FSA are not generally included in taxable income.

Money in an FSA must be used up each year, or the remaining amount is taxable; whereas an HSA balance can remain in your account, accruing interest until needed.

How to calculate taxable income

Now that you've learned about taxable income and ways to lower it, let's dive into how to calculate it. Here's a step-by-step guide to help you through it:

1. Start with gross income: The first step in calculating taxable income is to determine your gross income, or the total of all your earnings.
2. Subtract adjustments to income: Next, you'll calculate your AGI by subtracting any adjustments, also known as above-the-line deductions, from your gross income. These are deducted from your gross income before taxes and include things like retirement contributions and student loan interest.
3. Claim the standard deduction or itemize deductions: Once you have your AGI, you'll need to decide whether to claim the standard deduction or itemize your deductions, both of which reduce your taxable income. The standard deduction is a fixed dollar amount. Itemized deductions are specific, tax-deductible expenses, such as mortgage interest, property taxes, medical expenses, and charitable contributions. Choose the option that gives you the largest deduction.
4. Subtract deductions: After determining your total deductible amount, subtract it from your AGI. This gives you your taxable income.
5. Account for tax credits: Finally, after determining your tax liability, subtract any tax credits you're eligible for from it. Tax credits differ from deductions because they directly reduce the amount of tax you owe. That means credits can significantly lower your tax bill and could also lead to a bigger refund.

Learning how to calculate your taxable income will help you determine the taxes you owe. Once you subtract your withholdings and credits, any amount not covered by credits and withholdings is the amount you owe to the government. If your credits and withholdings are greater than your total taxes, you'll receive the remaining amount as a refund.

Is Social Security considered taxable income?

Many people rely on Social Security benefits as a critical source of income during retirement, and there is a common misconception that these benefits are tax-free. The fact of the matter is that a portion of your Social Security benefits may be taxable. Here’s what you need to know:

Your Social Security benefits may be taxable. How much depends on your combined income.

The IRS uses a tiered system to determine how big of a portion of your Social Security benefits are taxable, based on what it calls “combined income” or “provisional income.” Calculate your combined income by adding up your AGI (without your Social Security benefits), any non-taxable interest you’ve earned, and half of your total Social Security benefits.

If your combined income is more than $25,000 as a single filer or $32,000 as a joint filer, you may have to pay taxes on up to 50% of your Social Security benefits. However, if your combined income is more than $34,000 as a single filer or $44,000 as a joint filer, you’ll have to pay taxes on up to 85% of your Social Security benefits. If you are married filing separately, you have to pay taxes on 85% of your benefits.

This doesn’t mean that the tax you owe will be equal to 50% or 85% of your Social Security. Rather, it means that your AGI will include the taxable portion of your Social Security benefits.

Your taxable benefits are determined through the Social Security worksheet. You must determine your total income before you can determine your taxable Social Security benefits and your AGI.

Some states tax Social Security benefits, too.

While most states do not tax Social Security benefits, some do.

States that tax Social Security benefits

• Colorado
• Connecticut
• Kansas
• Minnesota
• Montana
• New Mexico
• Rhode Island
• Utah
• Vermont

The amount of Social Security that you must include in your state taxes depends on your AGI, filing status, and even your age in some states. However, the rules and thresholds vary by state, so it's essential to check the specific guidelines for your state, or ask your Tax Pro.

How do you reduce your Social Security tax burden?

If you want to avoid having to pay one big lump sum for taxes on your Social Security benefits when you file, you can opt to pay estimated taxes throughout the year or have federal income taxes withheld from your check.

Another thing you can do is withdraw your retirement from an account that isn’t subject to taxation, like a Roth IRA.

Determining your tax liability on Social Security benefits can be confusing to say the least. Work with a Tax Pro who can help you get it right.

Is retirement income taxable?

Retirement should be all about kicking back and enjoying the fruits of your labor, right? Well, when it comes to taxes, it's not always that simple. Let's break down whether your retirement income is going to be taxed.

Types of retirement income

Retirement income can come from various sources, and how it's taxed depends on where it's coming from and whether you've already paid taxes on that money. Here's a quick rundown:

• Social Security benefits: As noted earlier, depending on your total income, some of your Social Security benefits might be taxable.
• Pensions and annuities: These payments are usually taxable, but the tax treatment can vary based on factors, like whether you’ve made after-tax contributions.
• Traditional retirement accounts: Withdrawals from traditional 401(k)s and IRAs are generally taxable as ordinary income, because you didn't pay taxes on the contributions when you made them. The earnings in a traditional account are taxable when distributed.
• Roth retirement accounts: Withdrawals from Roth 401(k)s and IRAs are typically tax-free because you already paid taxes on the contributions, and the earnings are not taxable.

Don't forget about state taxes! Just like with federal taxes, the tax treatment of retirement income can vary by state.

Taxes can get complicated, especially when it comes to retirement income. If you're not sure about how your retirement income will be taxed, it's a good idea to consult with a Tax Pro who can help you navigate the ins and outs.

Is rental income taxable?

Yes, rental income is usually taxable. Whether you're renting out a house, apartment, condo, or even just a room in your home, the money you receive from your tenants is considered income by the IRS. Here are a few things you need to know about rental income tax:

• Report your rental income: When tax time rolls around, you'll need to report your rental income on your tax return. This is done using Schedule E (Supplemental Income and Loss), where you'll list all your rental income and expenses.
• Deduct applicable expenses: The good news is that there are many expenses you can deduct from your rental income to lower your taxable income. These may include mortgage interest, property taxes, insurance, maintenance and repairs, utilities, property management fees, and depreciation.
• State and local taxes: In addition to federal taxes, you'll also need to consider state and local taxes on your rental income. The tax treatment of rental income can vary by state, so it's essential to understand the rules and regulations in your area.

Navigating the tax implications of rental income isn’t always easy, especially if you own multiple properties or have unique circumstances. If you're unsure about how rental income will affect your taxes, it's a good idea to consult with a Tax Pro who can provide personalized advice based on your situation.

In conclusion, understanding taxable income is key to navigating the complex world of taxes and ensuring you’re meeting your tax liability. By understanding what counts as taxable income and what doesn't, you can make more informed financial decisions and avoid getting caught off guard when it’s time to file.

Determining your taxable income can be confusing, especially when you have rental income, Social Security benefits, or special circumstances. Work with a Tax Pro who can help you get it right.

About the Author

Mark Steber is Senior Vice President and Chief Tax Information Officer for Jackson Hewitt. With over 30 years of experience, he oversees tax service delivery, quality assurance and tax law adherence. Mark is Jackson Hewitt’s national spokesperson and liaison to the Internal Revenue Service and other government authorities. He is a Certified Public Accountant (CPA), holds registrations in Alabama and Georgia, and is an expert on consumer income taxes including electronic tax and tax data protection.

More about Mark Steber Our Editorial Policy