Navigating the world of taxes can be confusing and overwhelming. As a small solopreneur, it’s important to understand what’s considered taxable income and how you can use the tax code to reduce it when possible. This blog post will explain key concepts related to taxable income and provide useful guidance for reducing your overall tax burden. Whether you’re new to self-employment and filing taxes independently or just need a refresher on this evergreen topic, read on – we’ve got all the details covered!
What is taxable income and why it matters
Taxable income refers to the portion of your income that can be taxed by the government. This includes wages, salaries, tips, and any other sources of income you might have, like rental properties, capital gains from stock investments or gambling winnings.
It’s important to note that not all income is taxable, and there are certain deductions and credits that can lower your taxable income. But why does this matter? Understanding your taxable income can help you plan and budget for your future tax bill.
How to calculate your taxable income
We’ve got good news and bad news: The good news is that you don’t need to be a math whiz to calculate your taxable income! The bad news, it’s probably not going to be your favorite activity, however, calculating your taxable income is actually pretty straightforward and can help you anticipate your tax bill.
You can calculate your taxable income in two easy steps:
Step 1: Summarize your total income from all sources
List out your salary, investment income, business profit, rental income and any other miscellaneous income (gambling winnings, royalties, unemployment compensation, and social security benefits).
Step 2: Subtract adjustments and deductions from your total income
Adjustments to income are your IRA contributions, self-employed health insurance premiums, alimony payments, student loan interest or Health Savings Account (HSA) contributions.
Deductions are a little more complicated. Determine if it’s more favorable to take the standard deduction or to itemize deductions
Pro tip: If you don’t own your personal residence and/or make substantial contributions to charity (over $10K), you’ll likely take the standard deduction! Here’s a refresher on the standard deduction.
It can be a simple list, as easy as the example below. This example is for someone who is married and filing jointly:
So don’t stress—just take a deep breath, start a new spreadsheet and list it out!
Strategies to reduce your taxable income
When it comes to taxes, nobody wants to pay more than they have to. Fortunately, there are plenty of strategies you can use to reduce your taxable income and keep more of your hard-earned cash.
One of the easiest is to be educated on the available deductions and credits. Though they work differently, deductions and credits can ultimately help reduce your tax bill:
Tax deductions reduce your taxable income. These will include your contributions to an IRA, your student loan interest payments and either the standard or itemized deductions.
Here’s how it worksYou have income of $100K and claim the standard deduction for a single filer (which is $13,850 for 2023).
$100,000 – $13,850 = $86,150
Your taxable income is $86,150 . Your tax liability will be determined on your taxable income of $86,150
Tax credits reduce your tax liability.
Here’s how it works: Your taxable income is $86,150, resulting in a tax liability of $18,500. You are claiming an American Opportunity Credit for your college tuition payments, resulting in a credit of $2,500.
$18,500 – $2,500 = $16,000
Your tax liability is reduced to $16,000.
Though the additional tracking and organization is an extra effort, these steps can help you significantly reduce your tax bill and keep more of your money where it belongs – in your pocket.
Tax treatment of different types of income
When it comes to taxation, it’s important to understand the different types of income and how they are treated. Generally speaking, there are three main types of income – earned, passive and investment – and each is taxed differently.
- Earned income, which includes wages, salaries and self-employed business profit. Each of these are subject to payroll taxes as well as federal and state income taxes.
- Passive income, such as rental income or business income earned through a limited partnership, is subject to the same income taxes but not payroll taxes.
- Investment income, including capital gains and dividends, also has its own set of tax rules.
Though there are nuances in the way each of the income types are taxed, they all contribute to your taxable income and ultimately your tax bill.
What income is nontaxable
There are several types of nontaxable income, including gifts, inheritance, child support and certain types of insurance payments. In some instances, workers’ compensation benefits, certain retirement distributions and some disability payments are also nontaxable.
Keep in mind, even though this income is not taxed, the income still needs to be reported on your tax return. Knowing what income is nontaxable can help you minimize your tax liability and make the most of your finances.
By staying informed, you can confidently navigate the complexities of the tax code and keep your financial future secure.
Taxable Income FAQs
Why is taxable income important?
Taxable income refers to the portion of your income that can be taxed by the government. Understanding your taxable income means you can estimate your tax bill and plan or budget accorrdingly.
A friend/family member gifted me a lump sum of cash. Do I have to pay tax?
Cash gifts are not taxable to the recipient and do not have to be reported in your taxable income.
I have multiple revenue streams. Are all of them taxable?
There are two main types of income and they are taxed differently – but both are considered taxable income:
- Earned income (i.e. your salary, business profit,and tips)
- Investment income (i.e. rental income, capital gains from stocks, interest income)
Additional taxable income includes lottery/gambling winnings, retirement income, unemployment or settlement income.
Is pension income taxable?
Yes, pension income is generally taxable, although the amount of taxes you pay will depend on multiple factors such as your total income and tax bracket.
Is rental income taxable?
Yes, rental income is generally taxable, although you can offset your rental income with deductions related to maintaining the property. For example, you may deduct the mortgage interest, property taxes, utilities, repairs or landscaping expenses necessary to make the property ready and available for renters.
Is passive income taxable?
Yes, passive income is taxable. This type of income includes earnings from options trading, rental properties, dividend stocks, and other investments that don’t require active participation from you.
Is retirement income taxable?
Yes, retirement income is taxable, but the way in which it is taxed depends on the type of retirement plan you have.
With pre-tax retirement plans such as a 401(k), SEP IRA, or Traditional IRA, you can claim a tax deduction in the year you make the contribution, but you’ll pay income tax when the money is withdrawn during retirement.
In contrast, “tax-free” retirement plans such as a Roth IRA or Roth 401(k) require you to pay taxes in the year of the contribution, but you’ll have tax-free distributions upon retirement.
The different plans are designed to allow individuals to make contributions and pay taxes at a time when they anticipate being in a lower tax bracket. For instance, contributing to a 401(k) during your highest earning years results in a deduction now, while you’ll pay the tax on your retirement distributions when you’re no longer working and in a lower income tax bracket.
Is child support taxable income?
No, child support payments are not considered income by the IRS, however state laws may vary.
Is annuity income taxable?
Yes, annuity income is taxable, but similar to retirement income, the taxation depends on the type of plan.
If the annuity was purchased with after-tax dollars, a portion of the income received is tax-free. However, if the annuity was purchased with pre-tax dollars such as through an employer-sponsored retirement plan, the income from the annuity is subject to tax in the year received.
Are scholarships taxable income?
It depends. Generally speaking, scholarships used for qualified education expenses, such as tuition and textbooks, aren’t taxable. However, if the scholarship is being used for room and board or other non-qualified expenses, a portion may be considered taxable income.
Are tips taxable income?
Yes, tips are considered taxable income and are subject to federal income taxes, as well as Social Security and Medicare taxes. This includes all types of tips received in the course of employment, including cash tips, credit card tips, and tips received through an app.
- Taxable income is the portion of your income that can be taxed by the government, which includes wages, salaries, tips, rental properties, and gambling winnings.
- Calculating your taxable income is important since it helps you plan and budget for your future tax bill, and you can calculate it in two steps by summarizing your total income and deducting adjustments and deductions from it.
- Deductions and credits can help reduce your tax bill, where deductions reduce your taxable income and credits reduce your tax liability.
- Understanding the tax treatment of different types of income is crucial, as earned, passive, and investment income are taxed differently and can affect your tax bill.
- Some income is nontaxable, such as gifts, inheritance, child support, and certain types of insurance payments, but they still need to be reported on your tax return.
Staying informed and educated on the available deductions, credits, and tax rules can help you reduce your taxable income and keep your financial future secure.
Marissa Achanzar is part of the sales team at Collective and doubles as a content writer based in Roseville, California. After a successful seven-year-stint in public accounting, Marissa decided to pivot and put her tax compliance and client engagement experience to use by creating practical, people-first educational content.
Marissa is also the founder of Something Good Co., a non-profit that supports foster and at-risk youth in the Sacramento region. In her spare time, she enjoys exercise, trying out new recipes, dabbling on piano or guitar and won’t say no to a good TV/movie marathon. You can find her on LinkedIn or contact her at [email protected]