Taxable income is the amount of income you have to pay taxes on that you have received throughout the year such as rental payments, alimony, wages, and tips. However, not all of your income is taxable. The federal government allows you to keep some of your income completely untaxed through the use of exemptions and deductions. Once your taxable income is calculated, your income may be low enough to qualify for certain credits which reduce your tax bill dollar for dollar.
Taxable income is simple to calculate. The Form 1040 is like a paint-by-numbers guide to getting you there step by step. However, it can be time-consuming, especially if you want to run several scenarios to determine the best filing status, deductions and other factors you wish to manipulate to end up with the lowest tax liability. To make this process run smoother, create a Form 1040 in a spreadsheet such as Excel or Google Sheets with formulas, so you can easily manipulate numbers. Otherwise, hire a tax accountant. Consider doing a cost analysis of your time versus the money spent, considering how much you could save on your federal and state tax bills if you had a professional.
What Is Taxable Income?
Taxable income is the amount of income used to calculate your tax liability. It is calculated by adding earned and unearned income and subtracting deductions, exemptions, and credits. When calculating the tax liability of a business, income is considered revenue less expenses. From this number, deductions are subtracted to calculate how much income is taxable.
How to Determine Your Taxable Income
There are three simple steps you need to take to calculate your taxable income.
The first is to determine your filing status. If you're married, in almost every case the best option is to file jointly. To ensure this is the case for you, run the numbers under the scenarios of both you filing jointly and you and your spouse both filing separately. Filing separately allows you to divide up your deductions, but you cannot both use the same expenses to calculate those deductions. If you live in a community property state, you must calculate your tax liability based on joint income and expenses, then divide the results in half for each spouse. If you're not married, you'll file using the single status.
To file as the head of household, you must pay for over half of the household expenses, be considered unmarried for the tax year and have a qualifying child or dependent. To be considered unmarried for the tax year, you must file a separate return and your spouse must have not lived in the home for the last six months of the year. If you have a qualifying child or dependent and your spouse died in August, you must file as married for one final tax year.
A qualifying child is under 19 if he or she is not a student or under 24 if he or she is a full-time college student. The child must be younger than you and have lived in your home for over six months during the tax year. He must not have paid for more than half of his living expenses during the tax year and must be your biological child, stepchild, foster child, sibling, step-sibling, half-sibling or a descendant of one of these relatives.
Like a qualifying child, a qualifying dependent must live in your home for at least six months and you must provide over half of her financial support. This can include a biological child, stepchild, foster child, sibling, step-sibling, half-sibling, or a descendant of one of these relatives who is permanently and totally disabled if over 19 and not in school full-time (or 24 and in school). Your mother, father, stepfather, stepmother, niece, nephew, aunt, uncle, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law may also qualify as dependents. If you paid for over half of your parents' living expenses even if they did not live with you throughout the tax year, you may still file as head of household.
Income taxable by the Internal Revenue Service (IRS) includes earned income such as wages, tips, salary and income earned by any businesses you may have. Unearned income includes income you have received but not worked for. This includes dividends, interest, unemployment benefits, the distribution of tax-deferred retirement accounts, debt forgiveness, a portion of Social Security benefits, gambling and the sale of investments if you receive more than its cost basis. If you own part of a business but do not actively take part in it, any income you receive from this business is considered passive income. The most common categories of income are ordinary and capital income, passive and non-passive income and business and hobby income. To calculate your total gross income, fill in all relevant lines of the 1040 tax return and add them up. If you file separately, be prepared to prove which assets are in your name or your spouse's name.
Once you have added up all of your gross income on lines 7 through 21 on your Form 1040 and summed them up on line 22, you can then reduce your tax liability. Adjustments for taxable income include contributions to qualified Health Savings Accounts and IRA plans, student loan and mortgage interest, employment deductions and other expenses. On line 36, add up all adjustments on lines 23 through 35. Subtract line 36 from line 22 to get your adjusted gross income (AGI). From here, subtract deductions such as personal exemptions and the larger of the standard deduction or itemized deductions. Once you calculate this, you can determine if you're eligible for credits such as education credits or the child tax credit.
Why Knowing Your Taxable Income is Important
It is important to know your taxable income for planning purposes. If you have a 1099 job, you must be able to calculate accurately your tax liability so you can file quarterly tax returns and make estimated payments. If you will have over $600 in income in a tax year, you must file taxes on your income. If you owe more than $1,000 in taxes on your self-employed income, you must make quarterly payments towards the liability. For example, if you expect to have an income tax liability of $8,000, you must file quarterly tax returns and make payments of $2,000 per quarter. These payments may be mailed to the IRS made payable to the United States Treasury as either a money order or check. The address is on your Form 1040-ES and also included is a schedule of when the payments are due. If you prefer, you may make payments online through the Electronic Federal Tax Payment System by checking account draft or debit or credit card.
W-2 and 1099 Employee
If you receive both 1099 and W-2 forms consider adjusting your W-4 at your workplace to increase the amount of taxes withheld. You can either reduce the number of deductions you are claiming or opt for a specific additional amount to be withheld from each paycheck. If you can accurately calculate your total tax liability at the end of the year so you will owe less than $1,000 in income tax on your 1099 income, then you no longer must make quarterly payments.
Some of us have cash flow issues from time to time. To solve these issues, we may charge our credit card and incur interest because we cannot pay the balance off in full on time. Others incur late fees and utility restoration fees because we failed to pay our gas or water bill within the grace period. If you receive a large tax refund after you file your tax return, ask your employer's human resource department to adjust your W-4, so less money is being withheld from your paycheck. Even if you do not have cash flow issues, you can use this money to aggressively pay off debt, save up for a down payment on a house, prepay your property taxes or invest in high return stock market accounts.
Taxable income for individuals is the net of their gross income and allowable deductions, exemptions, and credits. It's also the basis for their state income if their state raises revenue through income tax. You can calculate this number in three simple steps. The first is to determine your filing status. For most of us, the decision is easy. We qualify as head of household, we are single, or we live in a community property state. However, some of us may find it difficult to determine whether we should file as married and separate or married and joint. This is where an Excel sheet with a copy of the1040 tax form with formulas comes in handy. Easily run different scenarios to determine which are the best for AGI, MAGI and more. It's important you have a solid understanding of what your taxable income will be at the end of the tax year. If you're a 1099 worker, you must file quarterly tax returns and make estimated payments if your tax liability is expected to be at least $1,000. Furthermore, many of us pay late fees and penalties and interest, because we cannot pay our bills on time and then get a large refund in February or March after we file our taxes. Avoid this by increasing the number of deductions you claim on your W-4 and eliminate some of these cash flow issues or make other decisions that will positively impact your financial health such as paying off debt, saving for retirement, or saving for a medical emergency.