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Taxable Income

Updated on May 4, 2024
Article byShrestha Ghosal
Edited byShrestha Ghosal
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Taxable Income?

Taxable Income is a part of the total income earned by an individual that is subjected to tax liability during a particular fiscal year. The tax brackets and the marginal tax rates are established on the basis of this income. It includes elements like salaries, wages, allowances, bonuses, and asset gains.

Taxable Income

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This income may be in the form of cash, services, capital, and properties. Individuals must report this income in their income tax returns unless an income is legally exempted as a tax liability. If they fail to file this income correctly, they may face grave legal consequences.

Key Takeaways

  • Taxable income is the part of an individual or business’s total revenue that is taken into account when computing their tax liabilities.
  • This income can come in the form of cash, offerings, funds, or assets.
  • The earnings may consist of two forms: earned income and unearned income. It consists of components such as capital gains, incentives, benefits, salaries, and wages.
  • Taxpayers pay income tax for a specific fiscal period based on this income. The Internal Revenue Service permits taxpayers to claim either a list of itemized exclusions or a standard deduction.

Taxable Income Explained

Taxable income is the portion of an individual or entity’s total earnings that is taken into consideration while evaluating their tax obligations. This is the amount of income that can be taxed, and it acts as a foundation based on which marginal tax rates and tax brackets are applied. It signifies the amount that the individual or organization owes to the government during a specific tax period.

This income can be of several types, including earned income and unearned income. It is calculated by adjusting the gross income and employing the applicable deductions on the total income. The Internal Revenue Service or IRS allows taxpayers to either claim a list of itemized deductions or standard deductions on the gross income. The taxpayers pay the income tax for a particular fiscal year based on this income.

Types

The types of taxable income are as follows:

  1. Income from business and investment: Self-employed individuals are taxed, especially on the income earned through their businesses. For instance, net income from rentals and earnings from partnerships are taxable.
  2. Employee perks and compensation: These are the most prevalent types of taxable earnings. They include salaries, wages, and extra perks.
  3. Miscellaneous income: It comprises income that does not fall into the other groups. It consists of components like death benefits, life insurance, and debt cancellation. Miscellaneous income also encompasses items like maintenance and child support, items exchanged in barter, and income generated from a hobby.

How To Calculate?

The steps to calculate this income include the following:

  • In the first step, individuals must record every payment they have received and compute the total income.
  • Then, they must calculate the income that is not earned. This income is recognized as the income acquired without having to work for it, which may include alimony, unemployment compensation, dividends, and revenue from real estate.
  • Next, they must select the filing status. The four filing statuses include single, married filing separately, married filing jointly, and head of household.
  • In the next step, individuals must lower their earnings. The Form 1040 includes a list of standard exclusions from gross income.
  • Finally, they must estimate the adjusted gross revenue. After adding up all of the reductions in the previous phase, the figure will be subtracted from the total or gross income to calculate the adjusted gross income. It represents the amount of income on which taxes are imposed.

Examples

Let us study the following examples to understand this income:

Example #1

Suppose Jake earns a yearly salary of $100,000. He also earned a rental income of $30,000 and a business income of $50,000 in a particular year. Jake deposited a portion of his earnings into health savings accounts, 401(k) and 403(b). During the end of the fiscal year, he had to estimate the portion of his income that had tax liability. Jake added all his earnings and applied the standard deduction to them. The resulting amount was his taxable income.

Example #2

In November 2023, the IRS announced its revised inflation-adjusted income tax rates and standard deductions for the fiscal year 2024. Every year, the IRS modifies tax brackets, the standard deduction, and several other tax benefits to adjust for inflation. The changes intend to safeguard taxpayers from the consequences of inflation. The US federal income tax system included seven tax rates: 10%, 12%, 22%, 24%, 32%, 35%, and 37%, which were applicable to a wide range of taxable income.

Taxable Income vs Non-Taxable Income

The differences between the two are as follows:

Taxable Income

  • This income is known as any individual’s or entity’s income that is taken into account for calculating their tax liability.
  • Each individual is required to pay income tax on their taxable earnings received within a financial year.
  • This income comprises capital gains, wages, salaries, pensions, rental income, investment income, business income, and unearned income.

Non-Taxable Income

  • Non-taxable income is money or assets earned from specific sources that are not taxable under federal or state income tax under the Internal Revenue Code or state tax laws.
  • Non-taxable income usually does not need to be disclosed on a tax return.
  • There are numerous cases where income is considered tax-free. However, each income category often comes with its own set of rules. Individual circumstances determine the legality of an income type that is non-taxable.

Taxable Income vs Gross Income

The differences between the two are as follows:

Taxable Income

  • This income is the adjusted gross income (AGI) amount minus any itemized reductions individuals are allowed to claim or the standard reduction.
  • The AGI is determined depending on certain above-the-line income adjustments, including student loan interest, contributions to an eligible individual retirement account (IRA), and specific contributions to health savings accounts.
  • Taxpayers can then claim either the standard deduction depending on their filing type or itemize the deductible expenditures they spent during the fiscal year.

Gross Income

  • Gross income is the basis on which the Internal Revenue Service (IRS) estimates the taxpayer’s tax obligations. It signifies the sum of earnings from all sources before any permitted deductions have taken place.
  • This income comprises revenue earned from salaries, wages, tips, and self-employment. It also comprises unearned revenues like royalties, dividends and interest from investments, and gambling rewards.
  • Some retirement plan withdrawals, which include required minimum distributions (RMDs) and insurance for disability income, are incorporated into gross income calculations.

Frequently Asked Questions (FAQs)

What reduces the amount of taxable income?

This income can be reduced with the help of employer-based accounts, like 401(k) and 403(b). These schemes enable individuals to reduce taxable income easily. The amount of money deposited in these accounts is not taxed until the user withdraws the entire money from the account. This framework helps reduce the tax burden for each year.

Do HSA contributions reduce taxable income?

The health savings account or HSA contributions help reduce taxable income. They allow for a tax-advantaged method to save money. The investment growth and qualified withdrawals in HSA are tax-free. HSA users may contribute the maximum limit amount every year as the amount deposited into this account is tax-free. The funds in the HSA carry over from one year to the following year. The accounts also stay the same even when the user switches jobs. This account ensures that the accountholders can save long-term for anticipated or emergency medical expenses.

Do charitable donations reduce taxable income?

Charitable donations may help reduce the tax levied on income. However, only donations in the form of cheques and cash qualify for a deduction in tax. The cash donations are usually not eligible for a tax deduction.

This article has been a guide to what is Taxable Income. We explain how to calculate it, its types, examples, and comparison with non-taxable & gross income. You may also find some useful articles here –

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