Understanding Taxable Income

You and your business pay tax based on taxable income, which does not include all income. Understanding taxable income allows for more effective tax planning.

What is taxable income?

Taxable income is the amount used to calculate federal income tax liability before tax credits and payments.

The term “taxable income" often gets confused with income subject to tax. Income subject to tax refers to individual income items—such as wages—that count as income on your tax return. Add all income subject to tax to determine total income. Taxable income equals total income minus deductions.

Non-taxable income—also referred to as exclusions from income or tax-exempt income—includes any income not subject to tax. The IRS does not consider non-taxable income as income at all, though it requires disclosure of some non-taxable income on the tax return for informational purposes.

Unlike deductions—specific expenses or allowances permitted to reduce taxable income—non-taxable income never affects the taxable income calculation. Despite its name, the term “total income" on a tax return does not include non-taxable income.

What is an example of taxable income?

Income subject to tax includes all income not specifically defined as non-taxable income. Which income items qualify as non-taxable varies between individuals, C corporations, estates, and trusts. Consult your tax professional if you aren't sure whether a particular income source qualifies as non-taxable.

For individuals, five common types of income subject to tax include:

• Wages
• Capital gains
• Trade or business income
• Pass-through entity income
• Most types of interest income

Non-taxable income sources for individual federal income tax include:

• Interest from municipal bonds
• Gifts—although the donor may owe gift tax
• Inheritances—although the estate may owe estate tax
• Most Roth retirement account distributions
• Most health savings account distributions

For an example of how to calculate an individual's taxable income, say Jane has $40,000 of wage income from her job, $25,000 of Schedule C business profit from her side business, $2,000 interest from municipal bonds, and a 2021 standard deduction of $12,550. She does not qualify for any other deductions.

Her total income on her individual federal income tax return equals $65,000—that's $40,000 of wage income plus $25,000 of business income. She must disclose $2,000 of municipal interest, but it doesn't count towards her total income because it's non-taxable income. With $65,000 of total income minus her standard deduction of $12,550, Jane has taxable income of $52,450.

How to find taxable income

The concept of taxable income applies to individuals, C corporations, estates, and trusts. Pass-through entities including S corporations and partnerships do not have taxable income on their returns, because most income and deductions flow to their owners' tax returns.

Individuals can find taxable income on line 15 of Form 1040. Line 30 of Form 1120 shows a C corporation's taxable income. Form 1041 reports taxable income for estates and trusts on line 23.

Individuals, C corporations, estates, and trusts all follow very different tax rules. Income subject to tax, nontaxable income, and allowable deductions vary significantly between individuals and the different entity types. However, the basic concept behind taxable income remains consistent. Total income—all income subject to tax—minus deductions equals taxable income.

Taxable income allows individuals and relevant entities to calculate federal income tax liability, subject to certain adjustments. The exact formula differs between individuals, C corporations, estates, and trusts.

Understanding the difference between taxable income and non-taxable income can help you or your business plan for taxes. Opting for non-taxable income over income subject to tax will reduce taxable income and thus tax liability. Knowing how to calculate taxable income also allows you or your business to pay the correct amount of tax.