Knowing how to manage your money means, among other things, knowing how to file taxes. It's also important to understand some basic concepts that determine how you'll be taxed and at which tax rate. Specifically, if you want to make sure you're fulfilling your obligations to the IRS, you must know how to calculate taxable income.
This five-step guide will walk you through the process of determining how much income you're going to be taxed on so you can make smart choices about claiming deductions when you file your federal income tax. This will also help you plan to have the money you need to pay your bill when tax day arrives.
Determine your filing status
The first step in calculating your taxable income is to determine your filing status. As the IRS explains, filing status determines whether you're required to submit a tax return and what income tax rate you’ll be subject to. It also affects what kinds of tax credits and deductions you're eligible for.
There are multiple different filing statuses, including:
- Married filing jointly or separately, each of which are available to married couples
- Head-of-household, which is available to single people who pay more than half their costs to run their household and who also have a child or other qualifying person they support.
- Qualifying widow/widower, which is available if you have dependents and your spouse died within the past two years.
The easiest way to determine your filing status is to use this IRS interactive tool.
Total up your income
The next step is to determine the total amount of taxable income you have to report to the IRS. The IRS indicates that "income" can include "money, property, or services." Both earned and unearned income count.
Earned income, or money that you earn by working, includes:
- Wages or salary
- Income from gig work, such as ride-sharing or food delivery
- Money from selling goods online
- Income from freelance work or from providing creative and professional services
- Money from a business or farm you own
- Income earned by acting as a minister or other member of a religious order
- Benefits you receive while part of a union strike
- Nontaxable combat pay
Unearned income includes:
- Income from investments, including capital gains distributions, taxable interest, and dividends
- Unemployment compensation
- Social Security benefits that are taxable
- Money from pensions and annuities
- Money you save because your debt is canceled
- Distributions of unearned income that come from a trust
There are other types of income that are generally nontaxable that you will not include in your calculations. These include:
- The value of meals and lodging your employer provides, if certain conditions are met
- Some employer-provided adoption assistance
- The value of an accident or health plan provided by an employer
- Survivor benefits for families of public safety officers killed in the line of duty
- Qualified Medicaid waiver payments received for caring for eligible individuals in Medicaid waiver programs
- Disaster assistance and disability payments received after a terrorist attack
When you add both earned and unearned income together, you'll get your gross income. Gross income is simply all income not exempt from tax, before deductions are claimed.
Total your above-the-line deductions
Above-the-line deductions are deductions anyone can take regardless of whether they claim the standard deduction or itemize (more about that later). These deductions are taken directly off your gross income.
Some of the most common above-the-line deductions include:
- Educator expenses that teachers pay for classroom supplies
- Some business expenses, such as travel costs for National Guard members who must travel at least 100 miles from home
- Health savings account (HSA) contributions
- A portion of your self-employment tax if you are self-employed
- Contributions to eligible retirement accounts, such as individual retirement accounts (IRAs)
- Student loan interest
- Alimony payments
These above-the-line deductions are also called adjustments.
Calculate your AGI
Next, you'll subtract your above-the-line deductions from your total taxable income in order to get your adjusted gross income or AGI. Say you have a gross income of $60,000 but contributed $5,000 total to your IRA and HSA. Your AGI would come down to $55,000.
That happens because AGI is simply your gross income minus adjustments. It is used for many purposes, including how much money you're taxed on, your eligibility for many federal and state benefit programs, eligibility for certain means-tested tax credits and deductions such as the child tax credit.
Subtract any further deductions
As confusing as it may seem, you aren't going to pay taxes on the full amount of your AGI either. Instead, you are allowed to take additional deductions from it. Note that tax credits reduce your tax bill, not your taxable income, and that’s why we’re not discussing them here.
You can either claim the standard deduction or itemize specific expenses to reduce your AGI. The standard deduction is available for anyone to claim to reduce their amount of income that is taxable, but the amount differs by filing status.
Here's the standard deduction amount based on your status:
- For single filers, it's $12,400 for the 2020 tax year and $12,550 for the 2021 tax year. The 2020 tax year is the year you'll be submitting your tax returns for in 2021.
- For heads of household, it's $18,650 for the 2020 tax year and $18,800 for the 2021 tax year
- For married joint filers its $24,800 for the 2020 tax year and $25,100 for the 2021 tax year
If you claim the standard deduction and are self-employed or run a business, you can generally also claim deductions for eligible business expenses such as the cost of goods sold, or other ordinary and necessary costs commonly accepted in your industry. These expenses are also obviously deductible if you itemize.
Most people find that claiming the standard deduction makes the most sense, rather than itemizing. However, if you itemize, you may instead be able to claim a deduction for certain specific expenses including but not limited to:
- State and local taxes that you paid, valued at up to $10,000. This includes state or local income taxes and sales taxes, as well as property taxes or real estate taxes.
- Mortgage interest you paid on loans up to $750,000 in mortgage debt
- Medical expenses you paid that exceeded 10% of your income
Whether you claim the standard deduction or itemize, the amount of your deduction(s) is subtracted from your AGI. Say you have an AGI of $50,000 but claim the standard deduction as a single filer. You'd subtract $12,400 from $50,000 to get $37,600 in total income that is taxable.
What about exemptions?
Taxpayers used to be able to claim a personal exemption for themselves and their dependents. These were valued at $4,050 prior to the passage of the Tax Cuts and Jobs Act. However, the tax reform law eliminated the ability to claim exemption until 2025 so they won't affect your taxable income this year.
How to get help with your taxes
If this all feels complicated or if you still aren't sure how to determine your own personal taxable income, there's help available. The best tax software aims to streamline the tax filing process by asking you a series of questions and using the information you provide to determine your taxable income and complete your IRS and state forms for you. Most of the best tax software providers also offer personalized help and support if you need tax filing assistance from an expert.
What income is not taxable?
Most income is taxable, including income from wages, from self-employment work, and money earned from investments. However, not all income is considered taxable. Some nontaxable income includes payouts from life insurance, money distributed from health savings accounts to cover eligible medical expenses, and a portion of your Social Security benefits if your income doesn't exceed certain thresholds.
Is taxable income gross income?
Taxable income and gross income are not the same thing. Gross income equals the total amount of earned and unearned income you received during the year. Above the line deductions, such as the deduction for IRA contributions or student loan interest, are subtracted from gross income to determine AGI. Either the standard deduction or itemized deductions are then subtracted from your AGI to determine taxable income.
How much can you earn without paying taxes?
Most people pay some type of tax on all their earnings from work. That's because payroll taxes (taxes for Social Security and Medicare) are collected by your employer on all wages up to an annual maximum limit. However, you will not have to pay federal taxes or file a federal income tax return until your income exceeds a certain threshold. That amount varies depending on the tax year and your filing status.
In general, for the 2020 tax year, if you are less than 65 and are not diagnosed with blindness, then you will need to file taxes once your income is at least $12,400. If you are a married couple filing jointly and neither spouse is under the age of 65 or blind, you will need to file taxes once your income is at least $24,800. For those who are older than 65, blind, or who use other filing statuses, the limits are higher.
The IRS has a helpful online tool you can use to determine whether you must file a tax return. You may also owe taxes to your state, depending where you live and the state’s rules for collecting them.
The five steps to calculating your total taxable income:
- Determine your filing status
- Total up your income
- Total your above-the-line deductions
- Calculate your AGI
- Subtract any further deductions
Calculating your taxable income is an important part of tax planning and tax preparation because this number is the key factor determining eligibility for certain tax deductions and credits. It also helps you better understand the amount of tax you'll have to pay the IRS and how things like tax brackets apply to you.
You can take these steps to calculate your taxable income, or submit your information to an online tax filing program to make the calculation simpler.