Posted by Michelson Law Office

How Taxable Income is Determined

How Taxable Income is Determined

The amount of money in earned income and unearned income and also creates a potential tax liability is called taxable income. Any income you receive for work and for other services you provided is called earned income while any wages, tips, and fees you receive are considered by the IRS as earned income. 

Breaking down Unearned Income

The money you get without actually directly working for it is called unearned income. A great deal of ground is actually covered by the term including the following categories:

  • Unemployment benefits and other federal and state financial benefits.
  • Cancelled debts.
  • Lottery winnings.
  • Profits from sold assets.
  • Alimony payments and child support.
  • Social Security and Medicare benefit your employer paid for you.
  • Severance pay.
  • Rental income from personal property.
  • Capital gains and losses when investing.
  • Stock dividends.
  • Bonuses and rewards like trips your employer paid for you.

Getting to know Nontaxable Income

The amount of money owed to the government may be a taxable income in gross income terms, but some forms of income are considered by the IRS as nontaxable.

However, it’s important to know that most forms of non-taxable income still need to be listed on your income tax return even though they’re not taxable.

Non-taxable income examples:

  • Cash gifts and inheritances.
  • Cash rebates from retailers and businesses.
  • Welfare income.
  • Damages from a physical injury, illness or disability.
  • Child support payments.
  • Hotel and restaurant services incurred when on the job.

There’s another category of income that the IRS may or may not consider as taxable. To see if any of the following potential sources of income are tax-exempt, it’s best to talk with a tax professional who can help you examine the income you’re earning:

  • Cost of living adjustments (like under Social Security)
  • Non-cash income
  • Collegiate scholarships
  • Life insurance;
  • State and local tax refunds or credits.
  • Deductions and Taxable Income

A substantial break on taxable income is provided by Uncle Sam in the form of the standard deduction on U.S individual and spousal tax forms. Itemized deductions offer more tax breaks and it requires you to record all the incurred expenses that you wish to use when filing your tax return.

What is the Standard Deduction?

When filing taxes, taxpayers can claim either the standard deduction or they can itemize their qualifying individual deductions. Your taxable income is cut by the standard deduction by a specific amount. The composition of itemized deductions includes individual deductions based on potential eligible expenses. You have the right to choose which deduction to claim which means you can lower your tax burden if you know which deduction is capable of doing so.

Remember that in December 2017, the new tax bill has been passed and the standard deduction levels went through several changes:

Here are the changes for the standard deduction from 2018-2025:

  • For married filing jointly or surviving spouse, $24,000 
  • For the head of household, $18,000 
  • For married filing separate or any single filer, $12,000.

What are Itemized Deductions?

Using itemized deductions is another way to slash your taxable income. When you choose this route, the savings can really add up. 

The IRS Tax Form 1040, Schedule E must include all itemized deductions for individuals and married taxpayers. Only the standard deduction can be taken on Tax Form 1040A or 1040EZ and doesn’t allow itemized tax deductions.

Itemized deductions are typically the following:

  • Mortgage interest;
  • Health care expenses;
  • Property taxes;
  • Charitable expenses;
  • Investment interest expense;
  • Tax preparation fees;
  • State and local taxes.

If you’re confused about whether to use itemized deductions or the standard deduction, consulting a tax professional will greatly reduce your time and effort in making a decision and even help you save some money as well.

How Taxable Income Is Done

The only main thing you got to remember when calculating taxable income is that it depends on your tax deductions, filing status, and the standard deduction. Taking the maximum amount of deductions possible to lower your tax bill should be your only goal.

Start by getting your calculator ready, then follow these steps to calculate your taxable income:

  • Determine your total taxable income for the year as well as both earned and unearned income.
  • Determine your adjusted gross income which is your gross annual income, with adjustments subtracted if needed.
  • Any standard or itemized tax deductions must then be subtracted from your adjusted gross income.
  • Then, tax exemptions such as dependent exemption must be subtracted.
  • Once any tax form adjustments, deductions, and exemptions have been subtracted from your gross income, you now have your taxable income figure.
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