Income can come from a variety of sources including hourly wages, business income, social security benefits, investment returns, and other places as well. Some income is taxable, but some is not. This can make it difficult to calculate your taxable income and how much you owe in taxes. Even though it offers a challenge, estimating your taxable income before filing tax returns helps you avoid huge surprises. It also allows you the chance to do some tax planning so you can reduce the amount owed or make adjustments to withholding.
What is “taxable income”?
All income is considered to be taxable according to IRS rules unless it is specifically exempt by law. That’s a rather broad definition. Some of the common sources of taxable income include:
- Salaries or wages from a job
- Tips over and above salaries and wages
- Most Capital Gains
- Self-employment, freelancing, or business income
- Rental income
- Gambling winnings
These income sources may be in the form of cash, but it’s still considered income. Property or services can also be taxable income. For example, if you barter to exchange services with another professional, you have to declare the value of their services as income on your taxes.
What Income isn’t taxable?
There are a few types of income that are not taxable. Federal income taxes are not levied on:
- Child support payments
- Municipal bonds interest
- Life insurance proceeds
- Disability benefits (if you paid premiums)
- Capital gains from the sale of a primary residence
Gifts do have special tax rules, but in general, they are not taxed. Inheritances aren’t federally taxed but states often levy inheritance taxes. Check out the IRS Publication 525 for the expansive list of taxable and non-taxable income.
Basics of Calculating Taxable Income
Even if your income falls into one category, you may not owe taxes on every single dollar. The IRS allows deductions that help to reduce gross income before arriving at your taxable amount. It only takes a few steps to calculate.
Step 1: Calculate Gross Income
Add up all your income. This will include what you made from freelancing, a side job, investment returns, wages from a job, and other sources. This total is your gross income, but remember, all of it will be taxed.
Step2: Make Income Adjustments
Schedule 1 of a tax return is where the adjustments to your income will go. Sometimes, they are referred to as “above-the-line” deductions because they appear above the Adjusted gross income line on the IRS Form 1040.
Some common adjustments to your gross income include contributions you made to a self-employed retirement plan, a health savings account, health insurance premiums for the self-employed, student loan interest, and more. The instructions on IRS Form 1040 will have a complete list.
Step 3: Claim the Standard Deduction or Choose to Itemize
You will get to choose between claiming a standard deduction or itemizing. Choose whichever is easier, or will give you the lowest tax bill. Itemizing deductions will involve keeping track of all your expenses and things you paid for throughout the year. The standard deduction is a flat amount the IRS pre-sets based on your filing status.
Step 4: The Qualified Business Income Deduction
Some business owners may be able to claim the Qualified Business Income Deduction. It’s worth up to 20% of the qualified business income. Owners of a pass-through business like an S-corporation, LLC, partnership, or sole proprietorship may be eligible. Subtract all the possible deductions from your gross income to calculate your taxable income.