At the beginning of every year, most individuals and families start collecting their annual pay statements and receipts in order to determine their taxable income. If you’ve ever done taxes on your own, you know how hard finding this number can be.
What is taxable income? Are taxable income and adjusted gross income (AGI) the same thing? More importantly, are there ways to reduce taxable income so that you pay less taxes every year?
Here’s everything you need to understand about taxable income – and why it matters throughout the year.
What Is Taxable Income?
The Internal Revenue Service (IRS) defines taxable income as any amount of earned money reported to the agency. Unless specifically exempted by law, most of your earned income is taxable.
Reported in several forms, examples of taxable income include wages, salaries, and any bonuses you receive from your work that are documented on Form W-2. This extends to income reported on IRS Form 1099 from freelance work, retirement accounts, gambling, or other activities. Realized gains from selling stocks – or unearned income from bank account interest or alimony payments – can also count.
Are Taxable Income and Net Income the Same?
Although they may be used interchangeably, taxable income and net income are not the same things. Your taxable income encompasses your gross earnings (minus any tax deductions you may have). Net income, however, is defined as your income after taxes. This may not encompass your entire taxable income every year.
Are Taxable Income and AGI the Same?
Although taxable and net income are not the same, the terms taxable income and AGI are often used interchangeably. Adjusted gross income reflects your total income minus any top-line deductions, including contributions to a 401(k) account. Taxable income refers to AGI minus any itemized deductions, including gifts to qualified charitable organizations or mortgage interest deductions.
Where Is Taxable Income Found?
According to the IRS, there are three primary forms of income: money, property, or services. However, depending on how you get paid for your work, your taxable income may be different.
The most common form of taxable income is money earned from a job. When you agree to work as an employee and accept a pay rate, that payment is considered taxable income. But that is not the only form of taxable income individuals can receive: Payments from pensions, retirement accounts, and even welfare can all be taxable income.
Does Taxable Income Need to be Money?
Money is not the only form of taxable income you may receive throughout the year. If you do work and accept bartered property (or an exchange of services as payment), those exchanges can also be considered taxable income. Although it is not common, if you accept property or exchange services, you are required to report it every year on your tax return.
Is Taxable Income for Self-Employed Workers Different?
Because self-employed workers do not automatically withhold taxes on their earnings, their taxable income may be different. As a result, independent or freelance workers are required to pay quarterly self-employment tax payments.
Every three months, self-employed people must determine how much they made over the period, then pre-pay their taxes using Form 1040-ES. Because it is only an estimate of their taxes for the quarter, their final tax bill at the end of the year may be different (based on their final annual taxable income for the year).
Why Is Taxable Income Important?
Taxable income is important because it ultimately determines how much of your income is paid to the government through federal income tax every year. How taxes are taken from your pay depends on whether you are a W-2 employee or are self-employed.
If you work at a job and collect a regular paycheck, your annual taxable income is determined by your income and withholdings from your W-4 Form. On every pay stub, your taxes will be broken down into three categories: income tax, Social Security tax, and Medicare Tax. While Social Security tax is a flat 6.2% and Medicare tax is 1.45%, your income tax is determined by how much you make every year.
2020 Federal Tax Brackets (Payable in 2021)
|Tax Rate||Single Filers||Head-of-Household Filers||Married Filing Jointly or Qualifying Widow Filers||Married Filing Separately Filers|
|10%||$0 - $9,875||$0 - $14,100||$0 - $19,750||$0 - $9,875|
|12%||$9,876 - $40,125||$14,101 - $53,700||$19,751 - $80,250||$9,876 - $40,125|
|22%||$40,126 - $85,525||$53,701 - $85,500||$80,250 - $171,050||$40,126 - $85,525|
|24%||$85,526 - $163,300||$85,501 - $163,300||$171,051 - $326,600||$85,526 - $163,300|
|32%||$163,301 - $207,350||$163,301 - $207,350||$326,601 - $414,700||$163,301 - $207,350|
|35%||$207,351 - $518,400||$207,351 - $518,400||$414,701 - $622,050||$207,351 - $311,025|
|37%||$518,401 and above||$518,401 and above||$622, 051 and above||$311,026 and above|
If you are self-employed, you may be required to pay taxes quarterly, which will encompass your income, Social Security and Medicare taxes. Any self-employed person who expects to owe more than $1,000 in taxes annually is required to pay the 15.3% self-employment tax every three months.
Regardless of how you are paid, you will still be responsible for paying the tax on your total taxable income (which is not withheld or pre-paid). Your IRS Form 1040 will help you determine if you owe income tax or if you are getting a tax refund from overpaying.
Examples of Income Tax
As the name implies, income tax is taken from the money you earn weekly, bi-weekly, monthly, or yearly. Examples of federal income tax – and how they apply to your life – depend on whether you work for a company or are self-employed.
For W-2 employees, one example of how income tax is applied starts with the pre-employment paperwork. Every worker must fill out Form W-4, along with any withholding forms filed with their state. Based on the elections from these forms, employers will withhold a portion of their gross pay for income tax, with the goal of satisfying their tax bill at the end of the year.
Paying income tax is different for those who are self-employed. Instead of paying taxes with every payment, their income taxes are paid quarterly to the IRS. To determine how much they must pay, self-employed individuals use Form 1040-ES to estimate their tax obligation(s). If their bill from taxable income is above $1,000 for the year, they are expected to pay estimated taxes quarterly.
These examples only pertain to federal income tax. Every state has different tax rules, so it’s important to check with your state and local government to determine what you may owe to those authorities.
Example of Self-Employed Business Tax
As an income tax example for the self-employed: If a single individual earns $40,000 through self employment as a sole proprietor, their expected tax bill is $8,680. Using Form 1040-ES, they would divide their total expected income tax by four, then pay quarterly payments of $2,170 to the government. Their final income tax bill may be different, based on business deductions and how they calculate their personal deduction.
Again, every state taxes self-employed persons different, so it’s important to check with your state tax authority to determine your local tax rate.
Taxable Income vs. Gross Income
Before you can determine your taxable income, you have to first determine your gross income. Gross income incorporates everything you earned during the calendar year, including your job wages, self-employment earnings, and anything you may have earned from “side gigs.” Your gross profits will often be reported on your Form W-2 and Form 1099 and be provided by the companies you worked for. However, taxable income is your gross income minus any deductions you may have over the course of the year.
Taxable Income Deductions
When filing your taxes, you will have two options for your taxable income deductions: You can either itemize all of your deductions or accept the annual standard deduction.
The standard deduction is a flat amount reduced from your gross income. The number is the combination of the basic standard deduction, along with an adjustment for your age. The standard deduction is also adjusted every year based on inflation.
2020 Standard Deduction for Tax Filers
|Individuals and Married Filing Separately||$12,400|
|Married Filing Jointly||$24,800|
In order to reduce their taxable income, tax filers also have the option of itemizing their deductions. The itemized deduction route is usually best for those who are writing off interest paid on their home and property taxes, make significant charitable contributions, have high medical bills, or maintain a home office.
Do Deductions Reduce Your Taxable Income?
As the name suggests, tax deductions are subtracted from your gross income to determine your final taxable income for the tax year. Regardless of which you take – the standard deductible or itemized deductibles – deductions ultimately reduce your taxable income, which is not reflected in your AGI.
Deductions can reduce your taxable income and help you save money on your taxes every year. Even if you don’t own a home, there are several deductions that can help you minimize your tax bill. Maintaining a home office, charitable donations, and retirement contributions are all easy deductions that can reduce your taxable income.
How Taxable Income Is Determined
Once you have your gross income determined, you can calculate your taxable income:
Taxable income = AGI - the greater of your itemized deductions or the standard deduction
Depending on your personal situation, you may not need to itemize your deductions to determine your taxable income. Instead, the standard deduction may offer a better (and easier) deduction from your final earnings.
What Is My Taxable Income?
When it comes time to file your taxes, your taxable income is determined by multiple factors. Depending on how you are filing, how much you earned, and how much you are deducting from your taxes, your taxable income may be different every year.
If you want to reduce your taxable income to its lowest number, consider talking to a Certified Public Accountant (CPA) about your personal situation. An accredited professional can help you determine the best route to file taxes and which deductions to take, helping you minimize your taxable income and keep more money in your pocket.
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Can Taxable Income Be Negative?
If you were unemployed during the year – or couldn’t work due to a disability or accident – your taxable income may actually be negative. This is known as a net operating loss (NOL). Individuals can experience a NOL if your AGI (minus deductions) comes out negative. While you can still receive a tax refund if you have a NOL, you may have to report the carryback for at least two years afterwards.
Can I Reduce My Taxable Income?
Yes: Nearly everyone can reduce their taxable income by taking several easy steps. The IRS offers deductions for family and dependent expenses, homeowner credit, education deductions, and more. The IRS website offers the entire list of allowed deductions that can dramatically reduce your taxable income.
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