What is taxable income, and how is it determined? Is taxable income the same as an income tax? Read on to learn everything about taxable income here.
Did you know that the average American household income is $74,664? And did you also know that the average American pays $10,489 in personal taxes?
This means that Americans are paying 14 percent of the average household’s total income towards tax. This figure excludes additional taxes, such as payroll taxes and sales taxes.
But have you ever wondered what is taxable income? Keep reading to find out more about taxable income and how to calculate it.
What Is Taxable Income?
Taxable income is the amount of an individual’s gross income that the government can tax. This is done yearly, so you may have heard of it being referred to as your annual taxable income.
An individual’s total annual income is often allowed deductions in a tax year. This means that they pay fewer taxes.
Taxable income is split into two categories; earned and unearned income. Earned income includes money you receive from an employer such as wages and bonuses. Unearned income includes money that you didn’t directly work for, such as interest and dividends.
What Does Taxable Income Cover?
While it’s true that wages, bonuses, commissions, and tips are all included as taxable income, they aren’t the only things. The Internal Revenue Service (IRS) also includes a range of other taxable incomes.
Other taxable income includes:
- constructively received income (money that was available to you, even if you weren’t in possession of it. E.g. a check you received in the previous tax year but didn’t cash)
- canceled debts
- fees for jury duty
- awards, prizes, and contest winnings
- freelance income
- fees for acting as an executor, trustee, or estate administrator
- capital gains
- security deposits (from tenants)
- interest and dividends
- unemployment benefits
- gambling, lottery, and sweepstake winnings
- fees for serving on a board of directors
- strike benefits
- profit on sales, even to friends or relatives
- assignment of income
- royalties and license receipts
- alimony received from an ex-spouse
- the value of bartered, non-cash services
- back pay
- embezzled money
- severance pay
If you aren’t sure about your taxable income, you should either speak to professional help or look on the IRS website. Have a look at IRS publication 525 to learn more about taxable and nontaxable income.
You don’t need to pay tax on all of your income. Some of your income is nontaxable, this means you don’t need to pay tax on it.
You don’t need to declare and won’t be taxed on a range of grants, payments, and awards. For example, you aren’t taxed on life insurance proceeds. If the beneficiary is you then the insurance policy death benefit won’t be taxable to you.
Other examples of nontaxable income include:
- workers compensation payments
- foster care payments
- child support payments
- Social Security benefits (dependant on income)
- disability benefits
- federal income tax refunds
- accident and personal injury awards
- scholarships and fellowship grants
- interest income on municipal bonds (that were issued in your state)
- debts that were canceled due to bankruptcy
- any money you receive as a gift (but you do owe tax on any income it produces such as interest)
- inherited assets
If you sell your primary residence, which you owned and lived in for two to five years before selling, then the capital gain from this sale is also included in nontaxable income. However, if it exceeds $250,000 (for a single taxpayer) or $500,000 for a married taxpayer then this is taxable.
How to Calculate Taxable Income
To calculate taxable income, you need to know what your total income for the year is. Then you can start taking away necessary deductions.
You can either take standard deductions or itemized deductions from your gross income to determine your taxable income.
Standard deductions are a single amount of money that is deducted from your total gross income.
When you get this figure, it is known as your adjusted gross income (AGI) and is used to determine your tax brackets and the amount of taxes you pay. In 2020, the standard deduction is $12,400.
Itemized deductions are individual tax deductions that are taken instead of the standard deduction. You can’t use both of the deductions.
Although standard deductions are easier to file for, itemized deductions may help some people spend less on their taxes. Property taxes, mortgage interest paid, medical expenses, and charitable donations are all common itemized deductions.
Some people may find that they have to file itemized deductions because they aren’t eligible for standard deductions. For example, married partners that file separately will have to file itemized deductions if their spouse is itemizing their deductions.
(Those who do choose the use itemized deductions must use Schedule A on the Form 1040 tax return).
You need to report your total income on Form 1040. This can be done under the section called Income.
Here you should include:
- your W2 income (if you haven’t worked this out already use this printable W2 form)
- taxable interest
- ordinary dividends
- capital gains
- Social Security benefits
- and any other type of income.
You can also list adjustments to income such as contributions to traditional IRA, student loans, alimony, and contributions to health saving accounts.
What is Form 1040 for? Form 1040 determines whether an individual taxpayer needs to pay more taxes or if they have paid too much tax and are eligible for a tax refund.
Familiarize Yourself With Taxable Income to Ensure You Don’t Pay Too Much or Too Little
Paying too much tax often means that you’re entitled to a tax refund, meaning you receive money back from the government. However, paying too little tax means that you might end up having to pay more money than you can afford.
To avoid paying too little or too much tax, make sure you use our guide to familiarize yourself with everything you need to know about taxable income. Now you know what is taxable income and what is nontaxable, you should be able to complete your tax returns with no problems.
If you found this article insightful, be sure to check out some of our other business articles.