Taxable income: What it is and how to calculate it

You don’t have to pay taxes on every cent you earn, especially if you can take advantage of popular deductions or tax breaks. However, figuring out how much of which income sources are taxable can be tricky. 

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What is taxable income?

Income refers to money, property or services you receive, typically in return for some service rendered or goods sold. 

Typical sources of income can include your pay as an employee, your earnings as a self-employed entrepreneur and your realized gains from investments. Yet an abundance of things can count: rental income, yields earned on a savings account or certificate of deposit (CD), lottery prizes, unemployment benefits, canceled debt and products you sell online. 

Most types of income are subject to taxation, but your specific tax bill depends on other factors. 

Is Social Security taxable income?

Your Social Security benefits are considered taxable income, though you’ll only pay income taxes under certain conditions. 

You could owe federal income taxes on up to 85% of your Social Security benefits on your 2023 return if one-half of your benefits, plus all of your other income, is greater than a certain amount. You could owe taxes if:

• You file as an individual, head of household or qualifying surviving spouse and your combined income surpasses $25,000.
• You file a joint tax return and your combined income is more than $32,000.

If your filing status is married filing separately, you’ll owe tax if: 

• Your income is greater than $25,000 and you lived apart from your spouse for all of the year.
• Your income is greater than $0 and you lived with your spouse at any point during the year.

You can request that the SSA withhold taxes throughout the year so that you don’t have a potentially nasty surprise in the form of a big bill come tax season. 

What income is not taxable?

Some employer, government and non-profit-provided benefits count as nontaxable income on your federal return, including: 

• Some health insurance benefits.
• Child support and adoption assistance benefits.
• Disaster relief aid.
• Death benefits from life insurance.
• Inheritance and gifts.

How to figure out your taxable income

Besides certain income sources being legally exempt from taxes, you can reduce your taxable income further with deductions. Here’s how to do that math:

1. Determine your filing status. Your filing status largely dictates your tax rate. The five filing status options are: single, married filing jointly, married filing separately, head of household and qualifying widow(er) with a dependent child.
2. Add up your income. Account for all the money and things of value that you received during the tax year. W-2, W-4 and 1099 forms are common sources of this information.
3. Subtract tax deductions. You might take the standard deduction based on your filing status or itemize your deductions. Which option you choose largely depends on which will save you the most money — the IRS shows that more than 87% of filers claimed the standard deduction in 2018 (the most recent data available).
   
   Itemization, however, provides an array of possible options: You could deduct home loan interest, student loan interest, the business use of your car or home, alimony payments and IRA deposits, to name a few. 

Imagine you earned $100,000 and take a standard deduction of $13,800. Your taxable income is $86,200. With an estimated tax rate of 16% (not to be confused with your tax bracket), your total federal income taxes for the year would be almost $13,800.

If you have tax credits, that comes into play later. Tax credits don’t reduce your taxable income; they do something better: They reduce your taxes directly. 

Continuing the example above, if you have $2,000 in tax credits from, say, an education tax credit, your tax amount would decrease from $13,800 to $11,800.

Strategies to reduce your taxable income

Contribute to an HSA

If you are enrolled in a high-deductible health plan, you can contribute to a health savings account (HSA), which offers a triple tax advantage — one of them being that you can make pre-tax contributions, which lowers your taxable income. 

If you contribute to an HSA through payroll deductions, the money goes in free of income, Social Security and Medicare taxes. On top of that, money in an HSA can be invested and grow tax-free and withdrawals for eligible medical expenses aren’t taxed.

You may be able to open an HSA even if you’re self-employed or your employer doesn’t offer health insurance, though there is a cap on how much money you can save in an HSA each year.

Contribute to your retirement accounts

Contributing to your retirement accounts may be one of the simplest ways to ease your tax burden.

Pretax contributions to an employer-sponsored 401(k) reduce taxable income on a dollar-for-dollar basis, said Anthony Basile, a certified public accountant (CPA) and Hofstra University professor. 

So, if you added $3,500 to your 401(k) during the year directly from your paycheck, your taxable income would be trimmed by that amount.

You don’t owe taxes on money in a 401(k), including contributions, employer matches and capital gains, until you make a withdrawal.

Another popular retirement option, an individual retirement account (IRA), also provides tax benefits. Your contributions to a traditional IRA might qualify for tax deductions. Meanwhile, contributions to a Roth IRA offer long-term tax advantages since contributions have already been taxed. 

Cover legitimate business expenses

If you’re an entrepreneur, you could pay for business training, buy equipment or carry out other business transactions before the end of a tax year to qualify for deductions, said Jeffrey Wood, a CPA and certified financial planner at Elysium Financial in South Jordan, Utah.

Maximize deductions and credits

Identifying deductions and credits that apply to your tax situation, said Dr. Lei Han, a CPA and associate professor at Niagara University, Ones you might overlook include deductions for student loan interest or home offices, and credits for energy-efficient home upgrades.

Donate to charity

Donations to eligible charities may qualify for tax deductions if you itemize deductions on your federal tax return. Gifts to people aren’t tax-deductible.

Tax-deductible contributions are limited to nonprofit religious, education and charitable groups that the IRS classifies as 501(c)(3) organizations. Both cash and non-cash donations might be tax-deductible.

Frequently asked questions (FAQs)