Money can be confusing, especially when it comes to taxes. One of the most common questions is, “What is taxable income?”
Taxable income refers to any earnings the government can tax. But there’s more to it than that. Knowing what counts as taxable income is crucial for filing your taxes correctly. Doing so can help you avoid surprises later.
So, what does taxable income mean? Let’s discuss everything you need to know about taxable income.
- Taxable Income Definition
- What Is Considered Taxable Income?
- What Doesn’t Qualify as Taxable Income?
- How to Calculate Taxable Income
- Ways to Lower Your Taxable Income Legally
- Navigating Your Tax Responsibilities
Taxable Income Definition
Let’s define taxable earnings to help you understand what it means. When you file your taxes, you’re telling the government about all the money you made during the year that they can tax. This is what many know as taxable income.
Think of it this way: if you earn it or receive it as payment, chances are it’s taxable. This includes what’s on your paycheck and other earnings you might not expect.
What Is Considered Taxable Income?
Understanding what is considered as income for taxes helps you stay on top of your tax obligations. Here’s a list of taxable income sources:
Employment income
Employment income includes all the money you earn from working a job. Your regular paycheck, overtime pay, tips, bonuses, commissions, and severance pay are taxable. If you get back pay from a workplace dispute, that’s also taxable.
Business income
When you work for yourself or own a business, your profits are taxable. This covers income from the following:
- Freelance work
- Running your own company
- Being part of a business partnership
- Making money from farming
After subtracting your business expenses, the remaining profit is your taxable income.
Investment income
You need to report the money you make from investments on your taxes. This includes:
- Interest from your bank accounts
- Stock dividends
- Profits from selling investments (capital gains)
- Rental income from properties you own
- Gains from cryptocurrency trading
Miscellaneous income
Several other types of money you receive during the year are taxable. This includes:
- Gambling winnings
- Jury duty pay
- Unemployment benefits
- Some Social Security benefits
- Prizes or awards you win
- Forgiven debts
- Alimony from a divorce (depends on the year the divorce was finalized)
You’ll receive tax documents from all income-earning sources sometime in January or early February. Save these and keep them in a folder because you’ll need the information to file your taxes.
What Doesn’t Qualify as Taxable Income?
Not all the money you receive counts as taxable earnings. The IRS expressly excludes certain types of income from taxation. This means you don’t have to report it on your tax returns.
Here’s what you generally don’t need to pay taxes on:
Insurance and benefit payments
Life insurance payouts and workers’ compensation benefits aren’t taxable. You also don’t have to pay taxes on most health insurance benefits from your employer or veterans’ benefits.
Family-related income
Money you receive as child support is tax-free. Most inheritances don’t count as taxable income either. If someone gives you a gift under the annual gift tax limit, you also won’t pay taxes on that.
Government assistance
Need-based welfare payments that help with basic living expenses aren’t taxable. This helps ensure people receiving aid can use the full amount for their needs.
Education support
Scholarships that cover your tuition and books aren’t taxable. This is true if you use it for qualified education expenses. However, scholarship money used for room and board is typically taxable.
Certain investment income
Interest you earn from municipal bonds (investments in local government projects) is usually tax-free. This is different from regular bonds, where you do have to pay taxes on the interest.
When determining if you need to file taxes, check the minimum income required to file. Not everyone must file a tax return based on their income level and filing status.
How to Calculate Taxable Income
Once you know what’s considered income for taxes, you can calculate your taxable earnings. Ultimately, this number determines how much you owe in taxes or what kind of refund you might receive.
Here’s a simple breakdown to help you calculate your taxable income:
- Start with gross income: Add all your income, including wages, business income, and other taxable earnings. Gather all necessary documents.
- Subtract above-the-line deductions: These tax write-offs reduce your taxable income. This may include student loan interest, self-employed health insurance, IRA contributions, educator expenses, and alimony payments (for divorces finalized before 2019).
- Calculate adjusted gross income (AGI): This is your income after above-the-line deductions. AGI affects your eligibility for certain tax benefits.
- Calculate final taxable income: Subtract either standard or itemized deductions from your AGI. The result is your taxable income.
Ways to Lower Your Taxable Income Legally
Lowering your taxable income reduces the amount of money the IRS can tax. This doesn’t mean you’re earning less money. Instead, it means you’re taking advantage of tax breaks the government offers to help you save on your taxes.
There are several legal ways to reduce your taxable income, such as:
Contributing to a retirement plan
One of the simplest ways to lower your taxable income is through retirement accounts. Contributing to traditional IRAs and 401(k) plans reduces your annual taxable income. If you’re over 50, you can make extra catch-up contributions to save even more.
Tax-advantaged accounts
Special accounts like Health Savings Accounts (HSAs) and Flexible Spending Accounts (FSAs) let you use pre-tax dollars for medical expenses.
You can also use 529 education plans to save for education expenses. However, these contributions aren’t tax-deductible federally. Deductions for these plans are also not available in every state.
Tax credits
Unlike deductions, tax credits directly reduce your tax bill. You may qualify for the Earned Income Tax Credit (EIC), Child Tax Credit, or credits for education expenses. Energy-efficient home improvements might also qualify for tax credits.
Business deductions
Owning a business or being self-employed is one of the most common reasons you might owe taxes. However, you also benefit from business deductions that lower your taxable income. You can deduct home office expenses, business travel, and vehicle use. Just make sure to keep good records to support these deductions.
Navigating Your Tax Responsibilities
Understanding your taxable income helps you make good financial decisions throughout the year. Knowing which income is taxable, keeping accurate records, and using legal tax strategies can help you save more money.
Sun Loan offers practical tax services to help you get the most from your refund. Our team can help you file and maximize your return with convenient online, in-person, and drop-off options. Visit your local Sun Loan branch to learn how we can support your tax needs.
