Taxable income is the portion of an individual’s or a corporation’s income that is subject to taxation by a governing body, such as the federal government, state government, or other tax authorities. It is calculated by taking the total income and adjusting for various allowances, deductions, and exemptions that are permitted by the tax code.
For individuals, taxable income is generally derived by making adjustments to gross income:
- Gross Income: This includes wages, salaries, business income, rental income, interest, dividends, and other forms of income.
- Adjustments: These might include student loan interest, contributions to certain retirement accounts, alimony payments (for divorce agreements in place before 2019 in the U.S.), and other adjustments.
- Deductions: Taxpayers may choose to itemize deductions or take the standard deduction, depending on which is more favorable. Deductions can be for things like mortgage interest, state and local taxes, charitable contributions, medical expenses exceeding a certain threshold, and more.
- Exemptions: These reduce taxable income based on the number of persons supported by the taxpayer’s income (though note that the Tax Cuts and Jobs Act of 2017 suspended personal exemptions in the U.S. until 2025).
- Credits: These are subtracted directly from the tax liability (rather than taxable income). Examples include the Child Tax Credit or the Earned Income Tax Credit in the U.S.
For corporations, taxable income is usually calculated as:
Revenues (from sales, services, etc.)
- Cost of Goods Sold (costs directly associated with producing goods or services)
- Operating Expenses (salaries, rent, utilities, marketing, etc.)
- Interest Expenses
- Depreciation and Amortization
+/- Other adjustments (based on tax code provisions)
= Taxable Income
Taxable income is a crucial figure because it determines the amount of tax an individual or corporation owes for a specific period. The tax rate applied to taxable income varies by country, jurisdiction, and the specific income bracket into which the taxable income falls.
Example of Taxable Income
Let’s walk through an example of how an individual might calculate taxable income.
John’s Income and Expenses for the Year:
- Total Earnings (Gross Income):
- Salary: $60,000
- Dividend Income: $1,000
- Interest from Savings: $200
- Student Loan Interest: $1,500
- Contribution to Traditional IRA: $3,000
- John doesn’t have many itemized deductions like mortgage interest or substantial medical expenses. So, he opts for the standard deduction, which, for the sake of this example, we’ll assume to be $12,000 (though this figure can vary based on tax year and filing status).
Calculation of John’s Taxable Income:
- Calculate Adjusted Gross Income (AGI):
- AGI = Gross Income – Adjustments
- AGI = ($60,000 + $1,000 + $200) – ($1,500 + $3,000)
- AGI = $61,200 – $4,500 = $56,700
- Subtract Deductions:
- Taxable Income = AGI – Deductions
- Taxable Income = $56,700 – $12,000
- Taxable Income = $44,700
Therefore, John’s taxable income for the year is $44,700. This is the amount on which his tax liability will be calculated, based on the tax brackets and rates set by the IRS or the respective tax authority in his jurisdiction.
It’s important to note that the numbers and categories used in this example are simplified for illustrative purposes. In real-life scenarios, the tax code may offer numerous other adjustments, deductions, credits, and factors that can affect taxable income. Always consult with a tax professional or use reliable tax software to ensure accuracy when calculating taxable income.