Taxable income is a subject on everyone’s lips at least once a year—or more if you file quarterly.
So how do you know what income is taxable and what isn’t? And how exactly do you calculate it? Let’s dig a little deeper and find out.
What Is Taxable Income?
Simply put, taxable income is the portion of your total income that can be taxed. Yes, that means a portion of your income isn’t taxable. We’ll get to why that is (cough, cough—tax deductions) later. But for now, let’s take a quick look at which kinds of income are taxable and nontaxable.
What earnings count as taxable income?
What do getting your paycheck, bartering, and winning the lottery have in common?
They all come with taxable income.
What? Yep. The truth is that the IRS taxes a lot of stuff, not just your annual wages or hourly salary—like most folks assume. If your income falls under any of the categories below, you have to report it on your federal tax return.
Income you earn: Whether you worked for someone or you were self-employed, your earned income is always taxable. This includes wages, salaries, commission, freelance earnings, holiday bonuses and tips.
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Winnings: You know how it goes. You win something big like a new Ferrari and you jump up and down—until someone tells you the bad news. You have to pay taxes on that. Yep. It’s true. You must report anything you win from gambling or betting—even prizes you win in a contest.
Money or property you gain: So maybe you didn’t work for a portion of your income. Maybe you earned money from your investments or you rented out your personal property. Is that income taxable? Yes. In particular, the IRS considers all of the following to be taxable income:
- Canceled or forgiven debt
- Interest or dividends from investments
- Real estate gains
- Rent from personal property
- Royalties from copyrights and patents
- Stock options
- Unemployment compensation
- Union strike benefits
- Gains of virtual currency (like Bitcoin)
A few of these types of income are capital gains—aka, money you earn from the sale of an asset such as a share of stock or a piece of real estate. These are taxed differently depending on how long you’ve owned it and in some cases the type of asset. For example, let’s say you sell the house you’ve lived in as your primary residence. As long as you’ve lived there full-time for two of the previous five years, you don’t pay any taxes on that sale up to $250,000 ($500,000 for a married couple).
Exchanges or bartered services: This one surprises people. Let’s say you’re a mechanic and your best friend—a carpenter—puts a new cabinet in your house. In exchange, you fix the radiator on his car. According to the IRS, both of you must declare the value of the other’s service as income.
Fringes: A fringe is a benefit your company gives to you. It can be anything from a paid gym membership to a Christmas bonus. Like prize winnings, you will be taxed on fringes.
What doesn’t count as taxable income?
Yeah, we know what you’re thinking. That’s a lot of taxable income. But believe it or not, the IRS doesn’t tax everything. Generally, here’s what the IRS usually considers nontaxable income:
- Accident and personal injury rewards
- Cash rebates
- Child support
- Federal income tax refund (duh!)
- Foster care payments
- Inheritances and money gifts
- Life insurance payouts
- Scholarships or fellowship grants
- Veterans benefits
- Welfare benefits
One quick warning before we move on. Some of these can be taxable under certain circumstances.
For example, let’s say you win a scholarship and you use it for tuition. Well, in that case, you wouldn’t have to worry about taxes. But if you use that money for room and board or you don’t use that money for school at all and you buy a truck instead, it would be taxable.
Our rule of thumb for deciding what’s nontaxable: Don’t guess. If there’s uncertainty, contact a tax professional who can look at the type of income and your particular situation.
How Do Tax Deductions Affect Your Taxable Income?
Earlier, we told you a portion of your income isn’t taxed. Well, let’s get down to it. You can reduce your taxable income. How?
With tax deductions.
What is a tax deduction?
Tax deductions reduce taxable income which, in turn, reduces your tax bill. For example, let’s say Tom earns $42,000 a year as a teacher. He takes the standard deduction, so he can take $12,200 off his annual income: $42,000 minus $12,200 equals $29,800. That means the IRS can only tax $29,800 of Tom’s income.1
Wait. Standard deduction?
Right, if you’re not sure about deductions, we can back up. When it comes to filing taxes, you can take a standard deduction ($12,200 for single filers or $24,400 for married couples filing jointly). Or you can itemize deductions from a list made by the IRS (like charitable giving or paid mortgage interest).
The thing to remember here is this: You can’t do both. You can take the standard deduction or you can itemize. How do you choose? Pick the one that saves you more money. If you’re not sure which one to choose, definitely contact a tax pro.
How Can I Lower My Taxable Income?
If taxpayers were puppies, this is when their tails would start wagging. Lower my taxable income? Yes! Finally. We’re at the part when we talk about how you can save money on your taxes.
1. Take advantage of tax deductions.
Yes, itemizing is a pain. But if it means saving more money, then don’t be lazy. Itemize.
2. Use adjustments to income if you can.
Adjustments to income are the tax filer’s secret weapon. They work like itemized deductions and the more you qualify for, the more you can take off your taxable income. But here’s thing: They’re not itemized deductions. That means even if you take the standard deduction, you can still use them.
Okay, so how do you know if you qualify for adjustments to income? You do if you answer yes to any of these questions:
- Did you pay student loan interest?
- Did you make contributions to a traditional HSA or IRA?
- Did you receive income from self-employment?
- Did you teach K–12?
- Did you pay a penalty for withdrawing from a savings account?
You can find more adjustments to income on the IRS website.
3. Contribute more to a traditional 401(k).
You don’t pay taxes on income that you invest in a traditional 401(k). For example, let’s say you make $53,000 and you invested $3,000 in a 401(k). Standard deductions and itemizing aside, you can take $3,000 off your taxable income.
So, if your employer gives you the option to invest in a traditional 401(k) and you’re on Baby Step 4, feel free to contribute to your 401(k) at least up to the employer match (if offered). You can put in up to $19,000 a year—and if you’re 50 or older, you can contribute an extra $6,000. In 2020 these amounts will increase to $19,500 and $6,500!2
Now, we want to be clear on something: We don’t want you to invest just to reduce your taxable income. Yes, it’s great that contributing to a traditional 401(k) can help reduce your tax bill. And if you have one, go for it. But there are other investing options out there—like a Roth IRA—that can help you grow your actual investment tax-free. So, once you meet the match in your 401(k), start investing in there.
What Tax Bracket Is My Income In?
Okay, once you calculated your taxable income, the next step is to determine your tax bracket. Think of tax brackets as an income range that corresponds to a tax rate. If that sounds like a mouthful, here’s what the new 2019 tax brackets look like.3
- 10% for incomes of $9,700 or less ($19,400 for married couples)
- 12% for incomes over $9,700 ($19,400 for married couples)
- 22% for incomes over $39,475 ($78,950 for married couples)
- 24% for incomes over $84,200 ($168,400 for married couples)
- 32% for incomes over $160,725 ($321,450 for married couples)
- 35% for incomes over $204,100 ($408,200 for married couples)
- 37% for incomes over $510,300 ($612,350 for married couples filing jointly)
The U.S. tax system is progressive (flashback to civics class), and that means the higher your taxable income, the more taxes you pay.
But here’s the thing, folks: You don’t just fall into one income range (unless your income is in the first range, then you do). Your income is spread across them. For example, let’s say you’re single and you have a taxable income of $55,000. Here’s what that would look like:
First tax bracket: $9,700 x 10% = $970.00
Second tax bracket: $29,775 x 12% = $3,573.00
Third tax bracket: $15,525 x 22% = $3,415.50
Total income tax: $7,958.50
And that’s the magic of the American tax system.
In 2020, these brackets adjust slightly due to inflation and will look like this:4
- 10% for incomes of $9,875 or less ($19,750 for married couples)
- 12% for incomes over $9,875 ($19,750 for married couples)
- 22% for incomes over $40,125 ($80,250 for married couples)
- 24% for incomes over $85,525 ($171,050 for married couples)
- 32% for incomes over $163,300 ($326,600 for married couples)
- 35% for incomes over $207,350 ($414,700 for married couples)
- 37% for incomes over $518,400 ($622,050 for married couples filing jointly)
In 2020, the standard deduction also increases to $12,400 for single filers and $24,800 for married couples filing jointly.
Get Your Taxes Done Right
Tax brackets, taxable income . . . If your head is spinning right now, you may need something stronger than aspirin to get your taxes done.
If your tax situation is simple, you should have no problems filing taxes on your own. But if your taxes are complicated (like if you have multiple sources of income or you own a small business), working with a tax pro may be a smart move. In these scenarios, a missed deduction could cost you a lot more than working with a pro—like one of our tax Endorsed Local Providers (ELPs).