What is Taxable Income? - Definition & Calculations

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and a PhD in Higher Education Administration.

Even if you pay someone to do your taxes, it is important to understand the basics of income taxes. In this lesson, we will define taxable income and discuss the basic steps of how you calculate taxable income.

What is Taxable Income?

Before we jump into the specifics of taxable income, let's make sure we are talking about the same type of tax. In the United States, depending on what state you live in, there are several different taxes. There is usually sales tax, which is a percentage tax added to purchases you make. There is gasoline tax, which is included in the price per gallon you pay at the pump. There may even be a state income tax. In this lesson, we are focusing on your federal income tax, or the taxes you pay to the federal government based on your annual taxable income.

Your taxable income is the dollar amount of personal income you make each year upon which the federal government collects taxes. This is not the same as your annual salary or the total amount of your bring-home pay for a year; in fact, it can be significantly less. As we'll discuss in this lesson, you (or your accountant) must take several factors into account when adjusting your gross, or total, income to calculate your taxable income.

Three Steps to Taxable Income

There are three basic steps or calculations that take you from your gross income to your taxable income. They are presented below with a brief description of the impact they may have on your final tax bill.

1. Calculate your gross income

First, you need to start with your gross income. Your gross income is all income you received throughout the year that is subject to tax. This includes wages, tips, interest from bank accounts, alimony from a former spouse, and other less common types of income. When you have the total from all of those sources, you add them up to get your gross income.

2. Subtract specific allowable expenses or adjustments

Depending on your filing status, for example, single, married, head of household, etc. and the form you use to file your taxes, the IRS allows adjustments, thereby not making you pay taxes on those expenses. These adjustments include alimony paid to a former spouse, some contributions to retirement accounts, and tuition and fees for college. After you subtract these deductions, you have what the IRS calls adjusted gross income or AGI.

3. Subtract personal exemptions and deductions

Deductions are expenses that the IRS allows you to subtract from your income, either in full or in part. Each year the IRS sets a standard deduction for each tax bracket. The standard deduction is an amount you can subtract from your AGI without any documentation - it is basically a minimum amount of tax-free income the IRS allows. A tax bracket is a range of income that determines what tax rate will be applied to your taxable income. Instead of using the standard deduction, you can take individual deductions. You only want to do this if the individual deductions add up to more than the standard deduction, but they often will. These individual deductions include expenses like mortgage interest, charitable contributions, unreimbursed job-related expenses, and large medical bills (above 7.5% of AGI).

After calculating your gross income, subtracting allowable adjustments, and then subtracting the standard or individual deductions, you have arrived at your taxable income. Depending on the tax bracket you are in, you then apply the applicable tax rate percentage to your taxable income. Once you do that, you have calculated your tax liability.

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