What Is Taxable Income And How Does It Work? (2024)

Most people get money from various sources: wages from a job, investment returns, income from a business, Social Security benefits, and more. Some of that income is taxable, and some isn’t, which makes calculating your taxable income—and estimating how much tax you’ll owe—challenging.

However, estimating your taxable income before filing your tax return can help you avoid surprises because it gives you an idea of how much you’ll owe.

Crunching those numbers before year-end also gives you a chance to do some tax planning to reduce the amount you’ll owe or adjust your withholding.

This overview will help you figure out what taxable income is and how to calculate it.

What Is Taxable Income?

According to IRS rules, all income is taxable unless it’s specifically exempted by law. That makes the definition of taxable income pretty broad, but some common taxable sources of income include:

• Wages or salaries
• Commissions
• Tips
• Bonuses
• Capital gains (with one exception, which we’ll cover in more detail later)
• Income from freelancing, self-employment, or a business
• Royalties and rental income
• Some interest and dividends
• Gambling winnings
• Unemployment compensation

Keep in mind, while many of these sources of income come in the form of cash, taxable income can also take the form of property or services. For example, say you’re a chiropractor and you provide services to an electrician in exchange for them rewiring your garage. In that case, each of you would have to declare the value of the other’s services as income.

What Types of Income Aren’t Taxable?

The good news is, several types of income aren’t taxable. You won’t owe federal income taxes on:

• Child support payments
• Interest from municipal bonds (this interest is also exempt from state income taxes if the bond was issued in your state)
• Life insurance proceeds
• Disability benefits (if you paid the premiums for the policy)
• Capital gains from the sale of your primary residence (limited to $250,000 in capital gains for single taxpayers or $500,000 for married couples filing jointly. Generally, you must also have owned and used it as your residence for at least two out of five years before the sale.)
• Gifts and inheritances

Note that gifts aren’t taxable to the recipient, but they do have special tax rules. Gift givers may have to file a gift tax return if they give gifts worth more than the annual gift tax exclusion ($16,000 for 2022 and $17,000 for 2023) to any one person during the year.

However, generally gifts made to your spouse for any amount aren’t taxable. Also, inheritances aren’t taxable at the federal level, but some states levy inheritance taxes.

IRS Publication 525 has a more expansive list of the types of income that are and aren’t taxable.

How to Calculate Your Taxable Income

Another piece of good news: Even if all your income falls into the taxable category, you won’t owe tax on every dollar. That’s because the IRS allows you to claim certain deductions that reduce your gross income to arrive at taxable income.

You can calculate your taxable income in a few simple steps.

Step 1: Calculate Your Gross Income

Add up all sources of taxable income, such as wages from a job, income from a side hustle, investment returns, etc.

To illustrate, say your income for 2022 includes the following:

• $75,000 in wages
• $1,000 in taxable interest and dividends
• $10,000 from a side hustle
• $5,000 in gifts from your grandparents

Of those sources, only the gift is non-taxable. So for tax purposes, your gross income is $86,000.

Step 2: Make Adjustments to Income

Adjustments to income go on Schedule 1 of your tax return. They’re also known as “above-the-line” deductions because they appear above the line for adjusted gross income (AGI) on Form 1040.

They include contributions to a health savings account (HSA) or self-employed retirement plan, health insurance premiums for self-employed people, student loan interest, and more. You can find more details on adjustments to income in the IRS Instructions for Form 1040.

Returning to the example above, say you contributed $3,000 to your HSA in 2022. When you subtract that amount from your gross income, your AGI is $83,000.

Step 3: Itemize or Claim the Standard Deduction

You generally have a choice between itemizing deductions or claiming the standard deduction, whichever option is easiest or will result in the lowest tax bill.

The standard deduction is a flat amount determined by the IRS based on your filing status. To itemize deductions, you have to keep track of amounts you paid for things like out-of-pocket medical expenses, home mortgage interest, state and local taxes (SALT), and charitable contributions. You list each of these expenses on Schedule A and attach it to your return.

Step 4: Consider the Qualified Business Income Deduction

Owners of pass-through businesses (sole proprietorships, partnerships, limited liability companies, and S corporations) can claim the qualified business income deduction. This deduction is worth up to 20% of qualified business income (QBI).

Your gross income minus all available deductions is your taxable income. Compare that amount to your tax bracket to estimate the amount you’ll owe before applying any available tax credits.

Back to our example: Say you claim the standard deduction in 2022 ($12,950 for single taxpayers) and don’t qualify for the QBI deduction.

That puts your taxable income at $70,050 (that’s your AGI of $83,000, minus the $12,950 standard deduction). This puts you in the 22% tax bracket.

If you’re still unsure whether certain types of income are taxable or which tax planning strategies are right for you, you may want to seek advice from a tax professional.