What is taxable income and how is it calculated?

What is taxable income and how do you determine it this tax year? Learning how to calculate your taxable income involves knowing what items to include and what to exclude. This post will break down the details of how to calculate taxable income using three steps.

Keep in mind, your taxable income determines how much you owe in federal and state income tax. As you prepare your tax return, it helps to understand how the tax law views your income in relation to how to determine taxable income.

What is taxable income?

Let’s start by covering the taxable income definition. For federal tax purposes, taxable income starts with all income received during the year unless it’s specifically tax exempt. Income that is subject to tax can include earned income (like wages and salaries), as well as unearned income (like investment income or profits from property sales).

Your taxable income is your gross income minus deductions you’re eligible for. It’s used to determine your tax bracket and marginal tax rate, so it’s important to know this amount as you file your income tax return.

Examples of income that is subject to tax include:

• Alimony payments (generally, for divorces before 2019)
• Benefit payments (such as distributions from traditional retirement plans, unemployment income, and up to 85% of your Social Security benefits depending on your income)
• Business income
• Certain cancelled debt
• Employment income (wages reported your W-2)
• Freelance or self-employment income (wages reported on Form 1099)
• Gambling winnings
• Investment income (this includes capital gains, dividends, and interest)
• Rental income
• Tax refund and rebates in some circumstances

What about nontaxable income? There are certain income sources that are usually nontaxable. They include:

• Child support payments
• Employer-provided insurance benefits
• Gifts to you (however, the person making the gift might owe the gift tax)
• Health savings account (HSA) withdrawals used to pay medical expenses
• Life insurance payouts
• Roth IRA and Roth 401(k) distributions
• Scholarships used to pay for tuition, fees, and related expenses
• Veterans benefits
• Worker’s compensation payments

Learn more about what the Internal Revenue Service (IRS) considers federal taxable income vs. nontaxable income.

How to calculate taxable income: Step-by-step

Now we’ll answer, “How is taxable income calculated?” In short, you’ll need to know your filing status, add up your sources of income, and then subtract any deductions to find your taxable income amount.

Step 1: Determine your filing status

The first step to calculate taxable income includes determining your filing status.

• If you aren’t married, you file your federal income tax return as Single or Head of Household or Qualifying Surviving Spouse. In some cases, married taxpayers who are considered unmarried for tax purposes may also file as Head of Household.
• For married taxpayers, in most cases the most beneficial option is to file jointly vs. separately. If you file jointly, add your incomes together to determine the total. You can combine your itemized deductions (or use the standard deduction for joint filers), and you pay your taxes jointly.
• If you file separately, add up your own income subject to tax, divide deductions as appropriately, (or use the standard deduction for separate filers) and pay your taxes separately. (You can’t use the same expenses to calculate the amount of your separate deductions. For instance, if you made a $5,000 donation from your joint banking account you cannot both deduct $5,000.) If you’re considering filing separately, work with a tax professional to understand how this decision impacts your overall tax burden and ensure you’re reporting income and deductions appropriately and considering credit limitations based on filing status.

Caution: Some states have property rules that require married couples who file separate returns to combine certain income and expenses owned by both spouses and then split the income and expenses equally on the returns. These states are known as community property states.

Step 2: Consider your types of income

The second step as you calculate taxable income includes adding up your income. Because the IRS requires you to report all income types, you should include side income, interest income, and additional wages or tips. This income is reported directly on your Form 1040 or Schedule 1. Use the lines on Schedule 1 to added up the different types of income.

Your total gross income is determined by adding up all types of income that you have received during the tax year.

• If you file separately, consider which income belongs on your and your spouse’s return. In some situations, such as IRA distributions, you will need to verify whose name is on which assets and report the income accordingly.
• If you live in a community property state, different rules apply, and you each should report 50% of the community income. Keep records of dividing up deductions since you both won’t be able to claim the same deductions. Use our easy-to-use income tax calculator to help figure it out. For more complex taxes, file with a tax pro.

Step 3: Calculate deductions and taxable income

The next step in how to determine taxable income is factoring in deductions that will lower your income. Once you report all of your income on your Form 1040 and Schedule 1.

Subtract either the standard deduction or itemized deductions (whichever lowers your taxes the most).  The resulting amount is taxable income.

How to reduce taxable income

Nobody wants to pay more than they should in taxes. We can help identify opportunities to lower your tax refund with these tax deductions:

1. Property taxes
2. State and local income taxes
3. Deductible Individual Retirement Account contributions (IRA)
4. Charitable contributions
5. Tax-deductible contributions to a Health Savings Account

Once you’ve calculated your taxable income and determined you tax liability, you may be eligible for certain tax credits that lower your tax liability, such as:

• Child Tax Credit  
• Education credits
• Child and Dependent Care Credit
• Premium Tax Credit

Help with tax preparation

Now that we’ve covered the taxable income meaning, how to calculate it, and how to reduce it, do you have more questions?  H&R Block is here to help. Whether you make an appointment with one of our knowledgeable tax pros or choose one of our online tax filing products, we’ll help you determine your taxable income as part of your tax preparation.