What is taxable income (and how can you reduce it)?

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When tax time rolls around, figuring out what kind of income you have to report to Uncle Sam can be confusing. Adjusted gross income, taxable income, investment income, interest income — all have an effect on your tax liability. And understanding what each calculation involves can help you reduce what you owe or develop a better tax strategy for next year.

Let’s take a closer look at what is considered taxable income, how to calculate it, how it affects your tax rate and how to reduce your taxable income.

In the simplest terms, taxable income is the portion of your earned and unearned income that is subject to income tax.

Taxable income includes salary or wages from work and other sources of income such as bonuses and tips, unemployment or disability benefits, and even lottery winnings. The Tax Administration (IRS) requires you to report all amounts “included in your income as taxable, unless specifically exempted by law.” In short, if you receive income in the form of money, property or services, the IRS may require you to report it as taxable income.

Calculating taxable income involves determining your adjusted gross income less deductions. (More on that below.) The final number is used to determine how much income tax you’ll pay on your federal and state income tax returns.

Here are some basic categories of income that the IRS categorizes as taxable rather than non-taxable.

1. Compensation of employees

Wages and earnings from your job fall into this group, but so do other types of compensation, such as tips, bonuses, and any compensation your employer pays you. Typically, these earned sources of income are listed on your W2, which you receive by mail or electronically at the beginning of the year.

2. Income from investments

If you generate income from certain types of business activities or investments, you must report it as investment or qualified business income. Rental income is a common example, as is interest earned from savings accounts, dividends, or capital gains you make after selling assets like stocks.

3. Additional benefits

Fringe benefits sound fun, but they’re really just a term for getting a tip, receiving a bonus, or earning extra income for services either as a salaried or hourly employee or independent contractor. And you must list them on your tax forms.

4. Various taxable sources of income

There is a fairly long list of other sources of income that the IRS taxes, such as ordinary income from partnerships, S corporations, fair market value of assets earned through exchanges, digital currencies, royalties and more.

Common sources of tax-free income

While it may seem like everything you earn is subject to income tax, there are a few exceptions. For example, earnings you repatriate as charitable contributions to a religious or non-profit organization will not be taxed, nor will capital gains from the sale of your primary residence.

Still confused? Use this chart as a quick reference on common sources of taxable and nontaxable income for federal tax purposes.

For some types of income, the answer to whether it is taxable is “it depends.” For example, alimony from divorces finalized before 2019 is taxable to the recipient spouse. For divorces concluded from January 1, 2019 and later, it is not taxable. And retirement accounts like IRAs, Roth IRAs, and 401(k)s have special rules. Generally, withdrawals from retirement accounts, known as required minimum distributions or RMDs, are subject to tax.

One big exception is Roth IRAs, which provide tax-free income in retirement.

Before you can sit down and calculate how much tax you owe, you need to crunch the numbers for yourself, your spouse and any dependents. This begins with W-2 forms, which reflect the traditional wages earned as an employee in Box 1 of the form.

If you are self-employed or work as an entrepreneur, you could receive Form 1099-NEC from a company or employer if your income during the year was more than $600.

Before you start doing the math, it’s important to decide on your income tax filing status. Your filing status determines your tax bracket and tax rate and the deductions and credits you may be eligible for. These are the application status options set by the Tax Administration:

Not sure which status applies to you? The tax administration has a archive status tool which can help you decide which is the best option for your situation.

Step 3: Calculate your gross income and adjusted gross income

Gross income is a calculation of your total income, including any wages, tips or bonuses, interest, dividends, rental income, and even capital gains. Once you determine that number, you can determine your adjusted gross income.

Calculating your adjusted gross incomesometimes called modified adjusted gross income, means making certain adjustments to your gross income. Here are some examples:

Work Pension Plan and IRA Contributions
Payment of alimony
Student loan interest
Health Savings Account (HSA) Contributions
Health insurance premiums for the self-employed

Your gross income minus these adjustments (also known as above-the-line deductions) is your adjusted gross income (AGI).

Step 4: Decide whether to take standard or itemized deductions

Once you’ve calculated your AGI, the final step is to subtract either the standard deduction or itemized deductions. The standard deduction is a set amount that is taken from your adjusted gross income depending on your filing status.

Itemized deductions are specific items for which you are entitled to deduct, which in some situations may be more than the standard deduction. Having a mortgage, significant medical expenses, or property loss due to a federally declared disaster are just a few scenarios where it would make financial sense to itemize your deductibles.

After subtracting the itemized or standard deduction, the remaining amount is your taxable income. Note that after calculating this number, you may still be eligible for certain tax credits, such as child tax credit, which could reduce your tax liability.

Although your federal taxable income will be calculated the same way regardless of which state you live in, each state has its own income tax rate and guidelines for determining each taxpayer’s state tax liability. Fortunately, 31 states (including the District of Columbia) have streamlined their tax return process by using federally reported adjusted gross income (AGI).

In addition, some tax preparation software can speed up the refund process by filing federal and state taxes simultaneously for some residents.

Reducing your taxable income can reduce the amount of federal income tax you owe. You can do this by using one or more of these strategies for better financial planning right now and better tax planning next year.

You can reduce your taxable income by increasing contributions to a traditional 401(k) or traditional IRA. If you’re under 50, you can contribute up to $23,500 before taxes to your employer-sponsored plan during tax year 2025. If you’re over 50, that number increases to $31,000 in annual contributions for 2025.

Keep in mind, however, that not all retirement savings will reduce your tax burden or provide immediate tax relief. For example, a Roth IRA is funded with subsequent dollars and will not reduce your taxable income. However, if the Roth IRA has been open for five or more years, the growth is tax-deferred, meaning your retirement payouts are tax-free.

Similar to retirement contributions, employer-sponsored health savings accounts (HSAs) and flexible spending accounts (FSAs) use pre-tax dollars to cover medical expenses and can reduce your taxable income.

HSA contribution limits are up to $4,300 individually or $8,550 as a family in 2025. FSA individual contribution limits are up to a maximum of $3,300 in 2025 or $6,600 for married couples contributing individually to separate FSA accounts.

Taxpayers can also reduce their tax bill or realize tax savings by itemizing deductions or using the comprehensive standard deduction.

In some cases, it’s best to consult with a tax professional, financial advisor, or certified public accountant (CPA) to see if they can help you get into a lower tax bracket or avoid paying long-term capital gains taxes by making charitable donations, qualified charitable distributions, or use of tax loss harvesting.

High earners and small business owners can benefit from professional advice.

Your annual income is listed in box 1 of the W-2 form you receive from your employer. While that number is a useful starting point for determining your gross income, your taxable income may be lower depending on the adjustments, deductions, and tax credits you qualify for.

Tax deductions are allowed for interest paid on all student loans, including federal loans, taken out by you, your spouse, or on behalf of your dependents. Maximum deduction, according to the tax administration, it is $2,500 per tax year, depending on your income entitlement.

If you recently had your student loans forgiven as part of the US bailout or some other federal action, those canceled debts are not subject to taxes.

While a qualified tuition program or 529 plan contributions won’t reduce your taxable income upfront, these tax-advantaged accounts are designed to pay for education expenses upfront and can be a tax-efficient strategy. Earnings accumulate tax-free, and the 529 plan beneficiary does not have to report distributions from the account as taxable income.

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