What is taxable income?

Elizabeth Rosen
by Elizabeth Rosen, Contributor

Taxable income, generally speaking, is the gross income of an individual or corporation, less any allowable tax deductions. Your taxable income is, in other words, the amount of your income that is subject to income tax.

In the USA, what qualifies as “taxable income” is defined in the Internal Revenue Code Section 63.  “Gross income” is defined in Section 61 of the Internal Revenue Code.

Taxable income can encompass more than just your annual salary.  Taxable income can include profits from stocks or real estate sales, winnings from the lottery, betting the dogs or horses, and winnings from any casino (domestic or abroad). Even the cash value of bartered items is considered taxable income.

Income that may be part of your gross income but is not identified as taxable income would include child support, proceeds from life insurance policies, inheritances, workers compensation payments, welfare benefits, compensation awarded as a result of physical injury, education scholarships or grants, and income paid to your retirement account (either a 401k or IRA, up to a certain amount).

From your gross income, allowable tax deductions as defined in Section 63 ― Subsection (a) covers itemized deductions; and subsection (b) covers standard deductions.  Note that you cannot reduce your taxable income with standard deductions if you itemize your deductions.

Itemized deductions that can minimize your taxable income include medical expenses and health insurance, as well as the cost of prescriptions, and the mileage to/from your doctors appointments.  Itemized deductions also include mortgage interest paid on a home loan, personal losses due to theft or accident, state and local income or sales taxes, property taxes (on real estate as well as personal property), charitable contributions to churches and other qualified nonprofit organizations, gambling losses  (provided they are offset by gambling winnings), and home office expenses.

The standard deduction to reduce your taxable income will be based on your filing status and changes from year to year, depending on inflation.  There is a higher standard deduction for individuals who are blind, and those aged 65 or older.  In addition to the standard deduction, you may claim deductions for real estate taxes, (net) loss sustained as a result of a Federally Declared Disaster, and taxes on federally-sponsored programs (which may include energy-efficient vehicle purchases, appliances, etc.).

In summary, taxable income is that portion of your gross income which is subject to taxation by the governing authority, less any allowable itemized or standardized deductions.

Types of Income Subject to Tax

The following categories represent types of income, which may be subject to Federal/State income tax, as set forth by the IRS:

  • Wages and salaries
  • Tip income
  • Interest received
  • Dividends
  • Business income
  • Capital gains and losses
  • Pensions and annuities
  • Lump-sum distributions
  • Rollovers from retirement plans
  • Rental income and expenses
  • Farming and fishing income
  • Earning for Clergy
  • Unemployment compensation
  • Gambling income and losses
  • Bartering income
  • Scholarship and Fellowship grants
  • Social Security and equivalent Railroad Retirement Benefits
  • 401(k) plans
  • Passive activities (losses and credits)
  • Stock options
  • Exchange of Policyholder Interest for stock
  • Canceled debt
  • Alimony and child support

For a complete list of the types of income subject to tax, see the IRS Publication 525 (Taxable and Nontaxable Income).

Income That Is Taxable Wages, Salaries, and Other Job-Related Earnings ― This may include advance commissions, back pays, bonuses, awards, cash gifts from your employer, fringe benefits, unemployment compensation, and childcare services.

Taxable Interest Income ― According to the IRS, taxable interest is defined as “any interest you receive that is credited to your account and can be withdrawn.” This may include interest from bank accounts, investment accounts, time deposits, loans you made to others, savings bonds, and debt instruments sold at a discount.

Miscellaneous Income ― This may include income from bartering, canceled debts, life insurance proceeds, survivor benefits, recoveries, welfare, and other public assistance benefits. Other types of taxable income may include: investment dividends income, interest on bonds, alimony, unemployment benefits, Social Security benefits, retirement plan distributions, jury pay, election worker pay, rental income, royalties, notary fees, and certain scholarships, fellowships, and grants.

Income That Is NOT Taxable

Types of income that are not subject to Federal tax may include the following:

  • Gifts and inheritances
  • Life insurance proceeds
  • Child support
  • Certain Veteran’s benefits
  • Insurance reimbursements for medical expenses not previously deducted
  • Some welfare payments
  • Compensatory damages for personal physical injury or illness
  • Workers’ compensation
  • Some qualified pension distributions for Public Safety Officers

For more information, please see IRS Publication 525, Taxable and Nontaxable Income.

Self-Employment Income

Self-employment tax (also called “SE tax”) is a Social Security and Medicare tax aimed mainly at individuals who are self-employed. The SE tax payments you make go towards your coverage under the federal Social Security system.  Social Security coverage essentially provides retirement benefits, disability benefits, health care benefits (Medicare), and survivor benefits. In general, you must pay Self-Employment Tax and file “Schedule SE” (on Form 1040) if either of the following applies:

  • Your net earnings from self-employment income were $400 or more
  • You work for a qualified church-controlled organization (other than as a minister or member of a religious order) that has elected an exemption from Social Security and Medicare taxes. In this case, you are subject to SE Tax if you earn $108.28 or more in wages from the church/organization.

To pay self-employment tax, you must have a Social Security number (SSN) or an individual taxpayer identification number (ITIN).

Note that there are special rules for fishing crew members, notary public employees, aliens, state or local government employees, foreign government employees, and international organization employees.

You should also note that whenever SE tax is mentioned, it generally only refers to Social Security and Medicare taxes, and does not include any other taxes that self-employed individuals may be subject to. Keep in mind that other information may be required for your particular type of business.

You may deduct ½ of your self-employment tax as an adjustment to your income on Tax Form 1040. Keep in mind that the Social Security Administration (SSA) places a time cap on how long you have to report self-employment income, and you can typically only get credit for self-employment income that is reported within 3 years, 3 months and 15 days after the tax year during which you earned the income.

Self-Employment Tax Rate

The SE tax rate for calendar year 2010 is 15.3% -- which breaks down to12.4% for Social Security (old age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance). The SE tax rate for calendar year 2011 is 13.3% -- which breaks down to 10.4% for Social Security and 2.9% for Medicare. Note that the Tax Relief Act of 2011 decreased the self-employment tax rate by 2% for self-employment income that was earned in 2011.

All of your combined earnings in the current year may be subject to any combination of Social Security tax, Medicare tax (2.9%), or railroad retirement tax (tier 1).

For tax years 2010 and 2011, the first $106,800 of your combined earnings may be subject to a combination of railroad retirement tax (tier 1), Social Security tax, and the Social Security part of self-employment tax. Any income you earn over $106,800 will not be subject to the Social Security tax.

If your wages (including tips) are subject to Social Security tax and/or railroad retirement tax (tier 1), and your wages are at least $106,800, you may not be subject to the Social Security part of the self-employment tax on any of your net earnings. Regardless, you must still pay the Medicare part (2.9%) of the self-employment tax on all of your net earnings.

If you do not file based on the calendar year, note that you must use the tax rate and earnings limit that is effective at the beginning of your tax year. Even if the tax rate and/or earnings limit changes during the year, you must continue to use the same rate and limit throughout your entire tax year.

Bear in mind, the self-employment tax rules above will apply regardless of your age – even if you have already begun receiving Social Security or Medicare benefits. For more information, please refer to the IRS Publication 533 (Self-Employment Tax).