Taxable Income: Understanding What It Is and How To Calculate It
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Summary:
Taxable income is a term that refers to the portion of your income that is subject to federal and state income taxes. It is important to understand what counts as taxable income and how to calculate it to ensure that you are paying the correct amount of taxes. This article will provide an overview of taxable income, types of income that count toward it, types of income that do not count toward it, how to calculate it, deductions and credits that can lower your taxable income, and common mistakes to avoid when calculating it.
What is taxable income?
Taxable income is the amount of income you earn that is subject to federal and state income taxes. It includes all sources of income, such as wages, salaries, tips, interest, dividends, capital gains, and business income.
Types of income that count toward taxable income:
Here are some common types of income that count toward taxable income:
- Wages, salaries, and tips
- Interest and dividends
- Capital gains and losses
- Business income
- Rental income
- Alimony received
- Unemployment compensation
- Social Security benefits (depending on your total income)
Types of income that do not count toward taxable income:
Here are some common types of income that do not count toward taxable income:
- Gifts and inheritances
- Life insurance proceeds
- Workers’ compensation benefits
- Child support payments
- Veterans’ benefits
- Scholarships and fellowships (under certain circumstances)
- Municipal bond interest
How to calculate taxable income:
To calculate your taxable income, you must first determine your gross income. Gross income is the total amount of income you earn from all sources. From your gross income, you can subtract certain deductions and exemptions to arrive at your taxable income.
Adjustments to gross income
After determining your gross income, you can then make adjustments to it by subtracting certain expenses. These expenses are commonly referred to as above-the-line deductions, and they include contributions to certain retirement accounts, student loan interest payments, and health savings account (HSA) contributions, among others.
The resulting figure after these adjustments are made is known as your adjusted gross income (AGI).
Tax deductions and credits
Once you’ve calculated your AGI, you can then apply tax deductions and credits to further reduce your taxable income.
Tax deductions are expenses that can be subtracted from your taxable income, reducing the amount of income that’s subject to tax. Common tax deductions include mortgage interest, charitable donations, and state and local taxes.
Tax credits, on the other hand, are dollar-for-dollar reductions in the amount of tax you owe. Some common tax credits include the Earned Income Tax Credit (EITC), the Child Tax Credit, and the American Opportunity Tax Credit (AOTC).
Deductions and credits that can lower your taxable income:
There are many deductions and credits that can lower your taxable income. Here are some common ones:
- Standard deduction or itemized deductions
- Personal exemptions
- Retirement contributions
- Charitable donations
- Medical and dental expenses
- Education expenses
- Child tax credit
- Earned income tax credit
Example of calculating your taxable income
To calculate your taxable income, you’ll need to subtract your deductions and credits from your AGI. The resulting figure is your taxable income, and it’s the amount of income that you’ll pay tax on.
For example, if your gross income is $50,000, you make $5,000 in above-the-line deductions, and you have $10,000 in tax deductions and credits, your taxable income would be $35,000 ($50,000 – $5,000 – $10,000).
Common Mistakes to Avoid When Calculating Taxable Income:
Here are some common mistakes to avoid when calculating your taxable income:
- Forgetting to include all sources of income
- Failing to take advantage of deductions and credits
- Miscalculating deductions or exemptions
- Not keeping accurate records of expenses
FAQs:
Do I have to pay taxes on Social Security benefits?
It depends on your total income. If your total income is above a certain threshold, you may have to pay taxes on your Social Security benefits.
Do I have to pay taxes on rental income?
Yes, rental income is considered taxable income.
How do I know if I should take the standard deduction or itemize my deductions?
You should choose the option that gives you the greater tax benefit. You can calculate both options and choose the one that results in the lowest taxable income.
Key takeaways
- Taxable income is the portion of your income that is subject to federal and state income taxes.
- It includes all sources of income, such as wages, salaries, tips, interest, dividends, capital gains, and business income.
- There are many deductions and credits that can lower your taxable income, such as the standard deduction, personal exemptions, retirement contributions, and charitable donations.
- To avoid common mistakes when calculating taxable income, make sure to include all sources of income, take advantage of deductions and credits, and keep accurate
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