What is Taxable Income?

July 27, 2023
Taxable income is the amount of earnings that are subject to taxation. Individuals, businesses, and other organizations are each responsible for reporting their income every year and paying any taxes that may be levied upon these earnings. In the U.S., an individual's taxable income is found by taking their adjusted gross income (AGI) and subtracting away any applicable deductions. Per the U.S. progressive tax system, the individual will then be responsible for paying taxes at the applicable rates for each bracket of income that this income amount breaches. A business or organization will also calculate its taxable income by taking the gross revenue it earned for the year and subtracting any applicable deductions. These may include business COGS (cost of goods sold) and certain other expenses.

What Counts as Taxable Income?

For individuals, the following are the most common types of earnings that count as taxable income.

Employee Compensation

Employee compensation generally refers to the wage or salary that a person earns for working a job. Depending on the position or industry, this will also include any:

●       Tips

●       Commissions

●       Fees

●       Profit sharing

●       Bonuses

●       Etc.

If your employer offers any fringe benefits, then these may also be considered taxable as well. For example, if you’re a manager and your employer gives you a fixed monthly car allowance, then this compensation is considered taxable income at the federal and state levels. Stock options and life insurance plans in excess of $50,000 are also taxed as fringe benefits.

Some fringe benefits such as health insurance, disability insurance, and tuition reimbursement are not considered to be taxable benefits.

If you’re self-employed, then you’re responsible for keeping records of the money you’ve earned and where it came from.

Business Income

Generally, any money you've earned from the business-related activity you're affiliated with counts as taxable income. This includes both active and passive income.

The following are a few common examples:

●       Rental income - Whether you own a property that you rent to tenants exclusively or lease a room in your house to a friend, the money you earn is considered to be taxable income.

●       Side hustles - If you've got jobs that you do on the side such as driving for Uber or delivering food for DoorDash. then you'll owe taxes on the earnings and tips you’ve received. This will also apply even if you do this work in addition to holding a full-time job.

●       Business ownership - If you’re a partner or invest in a business venture and received compensation for your stake as an owner, then this income is taxable. This is regardless of your involvement in the day-to-day activity.

Investment Income

Any earnings that have been collected from the sale or maturity of an asset will count as taxable income. A few common examples include:

●       Interest earned on a bank account, certificate of deposit (CD), or bond

●       Dividends received for being the shareholder of a dividend-paying stock

●       Premiums earned on the sale of options contracts

●       Gains are made from the sale of an asset such as an investment property. However, note that gains made on the sale of your primary residence are excluded up to a certain amount depending on your tax filing status.

●       Gains earned on securities (i.e. stocks) that were sold at a higher price than what they were purchased for. However, a sale has to occur before it counts as a "realized" gain and is therefore taxable. Until then, the gain is "unrealized" or sometimes referred to as a “paper gain”.

Note that in the U.S. long-term capital gains (i.e., securities that were held longer than one year) and qualified dividends are taxed at different rates than ordinary income. Short-term gains and non-qualified dividends are taxed the same as ordinary income.

Other Types of Income

The following other types of money received count as taxable income.

●       Social Security benefits - Benefits paid by the Social Security Administration are taxable. However, depending on your AGI a portion of these benefits may be excluded.

●       Unemployment benefits - Financial aid paid by the government while you were unemployed are taxable.

●       Digital Currencies - Although they are not technically considered securities according to the U.S. SEC (Securities and Exchange Commission), money made from the sale or receipt of cryptocurrency (such as Bitcoin) is considered to be taxable. This includes gains made by trading them on an exchange or as compensation for any contract work performed.

●       Royalties - Earnings you made from intellectual properties such as copyrights or patents.

●       Lottery and gambling winnings - Whether you win a few bucks on a scratch-off ticket or millions of dollars in Las Vegas, all winnings are considered taxable.

●       Lawsuit settlements - Unless otherwise exempt, most legal settlements are taxable.

●       Other unearned income - Financial gain from a canceled debt is generally considered taxable.

What Counts as Non-Taxable Income?

There are a few special types of income where taxes are not applicable. These include:

●       Earnings from investments within a Roth IRA (taken after age 59-½)

●       Insurance payments

●       Interest earned from municipal bonds

●       Gifts (under the annual federal gift tax exclusion amount)

●       Child support payments

●       Welfare payments

●       Etc.

When preparing an income tax return, the filer will generally be instructed to exclude any income from these sources.

How to Calculate Taxable Income

Most Americans will file their federal taxes by completing IRS Form 1040 each year before the following April deadline.

Here is the process Form 1040 uses for determining a filer's taxable income:

1) Pick a Tax Filing Status

U.S. taxpayers have the option of filing as:

●       Single

●       Married filing jointly.

●       Married filing separately.

●       Head of household

●       Qualifying widow(er) with dependent child.

For tax filing purposes, this is an important designation because it determines the income brackets for each tax rate as well as many other factors that will affect your tax bill.

2) Add Up Your Income

Add up all of your gross income for the year from all sources. These amounts will generally be available through various official tax documents sent by your employer, financial institutions, etc. In the case of any unreported tips or money that's been made on the side, these amounts will likely not have any documentation and need to come from your own personal records.

3) Make Adjustments to Your Income

There may be some circumstances where adjustments are permitted to some income sources. An example would be contributions to a tax-deferred retirement plan such as a traditional 401(k) or IRA. Apply these deductions by subtracting these amounts from your income in step 2.

This amount is known as your adjusted gross income (AGI). Note that your AGI is used for many other purposes throughout the tax filing process such as qualifying for various tax credits or programs.

4) Apply a Deduction

The IRS allows taxpayers to offset their income by a certain amount called a deduction. This will be done by subtracting their AGI by one of two amounts:

●       Standard deduction - This is a pre-set amount given by the IRS that is accessible to everyone. The amount will be based on your tax filing status and changes each year due to inflation.

●       Itemized deduction - This method gives you the opportunity to itemize specific expenses (such as mortgage interest and medical expenses) and take a deduction that may potentially be greater than the standard deduction.

Filers have the option of taking whichever deduction method reduces their AGI by the greatest amount. The resulting value will be the filer's taxable income.

Taxable Income Calculation Example

Suppose John and Mary earn a combined income of $140,000. On top of that, they had some CDs that matured and paid $5,000 in interest. They each contributed $10,000 to their workplace 401(k) retirement plans for a total of $20,000.

Putting this all together, John and Mary's adjusted gross income would be:

AGI = $140,000 + $5,000 - (2 x $10,000) = $125,000

Because John and Mary are married and file a joint tax return, they can take the standard tax deduction ($27,700 for 2023).

Therefore, their taxable income would be:

Taxable Income = $125,000 - $27,700 = $97,300

How is Taxable Income Reported?

Most working Americans will report their taxable income when they file their federal income tax returns for the year. Depending on the state and city that they work or live in, they may also have to pay taxes to these local treasuries.

According to the IRS, individuals and businesses are responsible for paying their taxes throughout the year as income is earned. This is also sometimes referred to as the "pay as you go" method.

For most individuals, this is not an issue because taxes are withheld from their paychecks automatically by employers and paid to the IRS. The final amount is then reconciled with either an additional payment or refund when the individual files their tax return at the end of the year.

People who don't have taxes automatically withheld (such as those who are self-employed or retirees) are responsible for calculating their taxable income and making estimated tax payments each quarter. Oftentimes these individuals will use software or a tax professional to help them estimate their taxable income and quarterly payments.

The Bottom Line

Both individuals and businesses are responsible for paying taxes levied on their earnings. This will be determined by the way they file their taxes as well as the types of income sources those earnings come from. Filers are responsible for paying taxes all year long and either making up the difference or receiving a refund when they file their tax return at the end of the year.