Taxable income: What it is, how to calculate it and how to reduce it
Taxable income directly affects how much you owe in taxes, so it pays to understand it. Knowing how to reduce your taxable income through, for example, deductible retirement contributions can lower your tax bill. Here’s how to figure out what counts as taxable income, how it’s calculated and steps you can take to reduce it.
What is taxable income
Taxable income is the portion of your gross income, aka total income, subject to tax. It includes wages, business profits, investments, and certain benefits — minus deductions like the standard deduction or itemized expenses.
Your taxable income determines your tax bracket and income tax rate. While some income is tax-exempt, most money, property, or services you receive are taxable, even if not reported on a tax form. Knowing what counts will help you plan and avoid surprises at tax time.
Types of taxable income
If you receive money in exchange for work, goods, services, or property, chances are it’s taxable. The IRS’s definition of taxable income includes various types of earned and unearned payments from work, benefits, investments and more. Here are some common examples:
- Wages and salaries reported on your W-2
- Self-employment income from freelance work, gig jobs or rental properties
- Investment income from dividends, interest and capital gains
- Retirement income from IRAs, 401(k)s and pensions
- Unemployment benefits
- Bartering income based on the fair market value of exchanged goods or services
- Royalties and partnership income from intellectual property, oil and gas or business ventures
Taxable vs. nontaxable income: How they differ
Knowing what qualifies as taxable income can help you avoid any surprises at tax time. In general, any money you earn or receive is taxable unless explicitly excluded by law.
The main difference is, you have to report taxable income to the IRS and pay income tax. Nontaxable income is usually tax-free, but some types may need to be reported.
Examples of nontaxable income:
- Gifts and inheritances under a certain limit
- Life insurance proceeds are usually tax-free when paid due to death
- Disaster wildfire relief payments
- Child support payments
- Welfare benefits and public assistance
- Voluntary employee salary reductions for health FSAs up to $3,200 (for tax years beginning in 2024)
- Certain disability benefits, including supplemental security income (SSI) payments
- Employer-provided health insurance
How to calculate taxable income
1. Determine your total income
Add up all sources of income, including wages, salaries, tips, interest, dividends, capital gains, business income, rental properties, retirement plan payouts, unemployment benefits, gambling winnings and prizes, digital assets and cryptocurrency, royalties and other taxable income.
These will be reported on tax forms like the W-2, 1099-INT, 1099-DIV, 1099-MISC, 1099-NEC and other relevant tax documents.
2. Know your filing status
Your tax filing status (single, married, head of household, etc.) affects your standard deduction and tax brackets. Choose the correct status to keep your calculations accurate. Use the IRS’s Interactive Tax Assistant to answer questions and determine your filing status.
3. Calculate your adjusted gross income
To find your adjusted gross income, or AGI, subtract above-the-line deductions from your total income. Above-the-line deductions are calculated before taking the standard or itemized deduction and may include IRA contributions, student loan interest and health insurance for self-employed individuals.
4. Account for nontaxable income
Some income may be partially or fully exempt from taxes, such as some of your Social Security benefits or qualified scholarships. Subtract any nontaxable income from your total.
5. Apply deductions
Subtract either the standard deduction or itemized deductions from your AGI.
Itemizing generally makes sense only if the total amount of your allowable itemized deductions is greater than your standard deduction. Itemized deductions can include medical and dental expenses, state and local taxes (including property taxes), mortgage interest and gifts to charities.
6. Determine your taxable income
After applying the appropriate deductions, the result is your taxable income, which is reported on line 15 of the current (2024) Form 1040 tax return. Your taxable income is used to determine your total tax bill for the year.
For the purpose of tax returns, you should also consider the impact of tax credits. While tax credits don’t directly affect taxable income, they can reduce the amount of tax you owe, to give you either a lower tax bill or a bigger refund.
How to reduce taxable income
Reducing your taxable income is a smart way to lower your overall tax bill. Here are several strategies to consider, depending on your situation:
- Contributions to traditional IRAs, if you’re eligible to deduct those contributions, reduce your taxable income. You have until the April 15, 2025, tax deadline to contribute to your IRA for 2024 — one of the very few ways to change your tax bill after the tax year ends. The maximum annual amount is $7,000 ($8,000 if you’re 50 or older) in 2024 and in 2025. The only limitation on deducting your IRA contributions comes into play if you or your spouse has a retirement plan at work — if you do, then there are income limits that restrict the deductibility of IRA contributions.
- Contributions to 401(k)s and similar workplace plans also lower your taxable income. In 2025, you can contribute up to $23,500 to a 401(k) ($31,000 if you’re 50 or older). That’s up from $23,000 ($30,500 if 50 or older) for 2024.
- Contributions to HSAs are tax-deductible — they are an above-the-line tax deduction. Plus, you can invest your HSA money and it will grow tax-deferred. And then, if you use the funds for qualified medical expenses, you won’t owe taxes on your withdrawals, giving you a triple tax benefit.
- Municipal bonds generally provide tax-free income. Many index funds or ETFs are more tax-efficient than actively managed funds, meaning you keep more of your money.
- Save for your child’s education with 529 college savings plans. You don’t pay tax on investment earnings used for qualified educational expenses.
- Donations to qualified charities can reduce your taxable income if you itemize, whether you give cash or property.
- While there’s an upfront tax cost, converting traditional IRAs to Roth IRAs during low-income years allows for tax-free retirement distributions.
- If you’re self-employed, you can deduct business expenses such as office rent, vehicle costs, and inventory, lowering your self-employment tax.
- Offset capital gains taxes by selling investments at a loss (known as tax-loss harvesting). Excess losses can reduce up to $3,000 of ordinary income, with any remaining losses carried forward.
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