In a nutshell, taxable income is the compensation or the amount of income of an individual or a business used towards determining the tax liability. Alternatively, it refers to the portion of the gross income that helps calculate the amount of tax an individual or an enterprise owes to the Government.
Taxable income is gross income or adjusted gross income minus all the deductions and exemptions for a particular year. To understand taxable income, you should know what gross income is.
Taxable income is not just one’s salary but also constitutes other compensations like commission, bonus, allowance, tips, wages and others. All these constitute gross income and, it’s the beginning from where, after making some allowable deductions, the actual taxable income is derived.
In short, gross income is all the income from all the sources before making allowable deductions. Gross income includes:
- Government benefits
- Income from gambling
- Unearned income like dividends
- Compensation received for unemployment
- Income from investments
- Select withdrawals from retirement accounts
- Income earned from lottery
- Miscellaneous income like cancelled debts
- Income earned from appreciated assets
- Rent from personal property
However, gross income includes more than these and almost anything not considered tax-exempt by the Internal Revenue Service.
To calculate taxable income for a financial year, knowing non-taxable income is equally important. There are a select number ofincome streams that are exempt from tax and don’t come under gross income.These comprise of:
- Child support payments
- Workers’ compensation
- Compensatory damages for physical injury
- Welfare benefits
- Supplemental security income
- Veterans’ benefits
- Employee achievement award [Subject to conditions]
- Cash rebates
To gain a complete understanding of taxable income, you should know the factors that affect taxable income. These deductions have a profound impact on the portion of your income that is taxable.
Deductions Affecting Taxable Income
There are two types of deductions that affect taxable income.
It’s that part of your income you can use to reduce your tax bill and, is not subject to tax. It’s applicable only when you don’t itemize your deductions [More of this later]. The standard deduction depends on your age, the filing status, and whether you are dependent or disabled.
In layman’s terms, the standard deduction is a single, no-questions-asked reduction in an individual’s adjusted gross income. The advantage is, it’s much faster and easy to claim and, you need not keeptrack of every qualifying expense.
Restrictions to standard deductions
There are limits imposed on whether a taxpayer can qualify for standard deductions. A non-resident individual and his/her spouse cannot claim it. A married person who files separately and whose spouse has filed for itemized deductions cannot file for the standard deduction.
These deductions are eligible expenses; there are several of these, that taxpayers can claim to decrease the taxable income. Which means you can choose from numerous individual tax deductions to itemize instead of the flat-rate, standard deduction.
Since there isa multitude of deductions available, itemized deductions can often be more than standard deductions. However, they require proof, and you need to maintain records and keep everything organized.
It’s also time-consuming as it involves the filling of several tax forms and supporting schedules.
Choosing Between Standard Deduction and Itemized Deduction
Choosing standard deduction or itemized deduction boils down to the total amount of deductions. If the standard deduction is less than itemized deduction, switch to itemize. If the standard deduction is more than itemized deduction, you can stick to the standard deduction.
Remember that you can choose either one of them to reduce your tax liability. You cannot do both.
Expenses that Can be Itemized
There is an extensive list of expenses that can be itemized and, there are limits and conditions applied on most items. In fact, some itemized deductions have been taken off somewhere in the year 2018. The list includes (But not limited to):
- 401(k) contributions
- Adoption credit
- Charitable donations
- Child tax credit
- Deduction for state and local taxes
- Educator expenses
- Gambling losses
- Home office expenses
- Investment interest
- Ira contributions
- Medical expenses
- Mortgage insurance premiums
- Mortgage interest
- Student loan interest
If you consider taking the standard deduction, the job is much easier but, you cannot deduct the above expenses. However, if you choose itemized deduction, you probably will save much more but, you need to provide supporting documents for audit purposes.
Taxable Income for Businesses
Businesses don’t consider the revenue generated as business income. They deduct permissible business expenses from gross sales to arrive at gross income. This is the net business income that is taxable.
Procedure Involved in Calculating Taxable Income for Your Business
You have to determine the gross sales
Arriving at gross sales is the first step to determine your business’s taxable income. This includes revenue generated from all the sources for a financial year minus all expenses.
Calculate the cost of sales or goods sold
This is only of those businesses that actually sell goods. You can subtract the value of inventory purchased from the total revenue generated. This also includes all other expenses that come under cost of goods sold. These include overhead costs, direct labour costs, storage, cost of raw materials and others.
Itemize your business expenses
There are some business expenses that are fully deductible and others, partially. Some of these include (But not limited to):
- Repairs and maintenance
- Salaries and wages
- Utility expenses
- Printing charges
- Legal fees
- Marketing and advertising costs
- Insurance costs
- Office supplies
- Bank and accounting fees
Subtract business deductions
Now, you need to subtract business deductions and credits including business interest, retirement plans and other related expenditure.
Determine the taxable income
In this final step, you subtract all the allowable tax deductions and credits from the gross income. This amount is taxable. In case the figure is in the negative, it means your business has suffered a loss for the particular financial year.
Other Business Expenses Allowed for Deduction
There are some expenses incurred by a business that are both personal and business-related. There are cases where a business owner uses his car for personal and business purposes. In such circumstances, the travelling expenses incurred for business purposes can be deducted.
Similarly, in a home-office set up, only that portion of the home used as office space is deductible. These are categorized under the listed property that serves business and personal uses.
Other Business Deductions
There are capital expenses that actually happen to be business assets. A business should capitalize on these assets and deduct over a specified number of years through depreciation. Most of these include furniture, computers, equipment, vehicles and many others.
Often, businesses give gifts to their clients or employees as a mark of appreciation. The cost of these gifts is also deductible subject to certain conditions. Expenses incurred on meals and entertainment are deductible up to 50 percent.
Taxable Income and Tax Bracket
A tax bracket is determined by and is an important component of your taxable income. Tax brackets are a series of divisions where income tax rates move ahead in a progressive tax system. In such a system, the tax rate increases as and when an individual’s or an enterprise’s income increases.
There are different dollar ranges for single filers, couples’ joint filers and couples filing separately. The inflation rate helps adjust the brackets accordingly every year using the Consumer Price Index.
Tax Rate and Tax Bracket
Every tax bracket has a specific tax rate, which happens to be the percentage at which your income is taxed, attached to it. Tax rates are called marginal tax rates that increase with each additional dollar of income. Your income will be taxed progressively and is subject to different tax rates.
However, the tax bracket doesn’t tell the exact amount you will be paying as tax. The government divides your taxable income into chunks that fall into specific tax brackets. Every portion is then taxed at the corresponding tax rate.
Progressive tax brackets can generate more revenue for the government while also offering tax rebates and tax deductions for individuals and businesses. However, there are arguments that a flat tax structure should be in place. The argument stresses that everyone is equal in the eyes of the law without any discrimination.
Another glaring loophole is the wealthy will possibly spend too much to exploit the law and find ways to pays less tax and, personal savings rate can reduce dramatically. But, considering the numerous benefits this system provides, it’s still the most effective way to plan and work for the welfare of the individuals, the businesses and the nation.