When tax time comes, figuring out what types of income you need to report to Uncle Sam can be confusing. Adjusted gross income, taxable income, investment income, interest income - all of these affect your tax liability. Understanding what's involved in each calculation can help you minimize the debt you owe or develop a better tax strategy for next year.
Let’s take a closer look at what taxable income is, how to calculate it, how it affects your tax rate, and how to reduce your taxable income.
Read more: Here are 7 free tax filing options
Simply put, taxable income is the portion of your earned and unearned income that is subject to income tax.
Taxable income includes wages or wages from work and other sources of income, such as bonuses and tips, unemployment or disability benefits, and even lottery winnings. The Internal Revenue Service (IRS) requires that you report "all taxable amounts included in your income unless specifically exempted by law." Simply put, 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 adjusted gross income minus deductions. (More on this below.) The final number is used to determine the amount of income tax you will pay on your federal and state income tax returns.
Read more: Expecting a refund? Here are 5 smart ways to use your tax refund
Here are some basic categories of what the IRS classifies as taxable and non-taxable income.
1. Employee salary
Your wages and earnings from your job fall within this range, but so do other types of compensation, such as tips, bonuses, and anything your employer pays you. Typically, these sources of income are reported on your W2, which you receive in the mail or electronically at the beginning of the year.
2. Investment income
If you receive income from certain types of business activities or investments, you need to report it as investment or qualified business income. Rental income is a common example, as are interest earned from a savings account, dividends, or capital gains realized on the sale of assets such as stocks.
3. Fringe benefits
Fringe benefits may sound fun, but they're really just a term that refers to receiving tips, receiving bonuses, or earning extra income through services as a salaried employee, hourly employee, or independent contractor. You need to account for them on your tax return.
4. Sources of miscellaneous taxable income
There is a long list of other sources of income that the IRS taxes, such as ordinary income from partnerships, S corporations, fair market value of assets acquired through barter, digital currencies, royalties, and more.
Common Sources of Non-Taxable Income
While it may appear that you are subject to income tax on all income you earn, there are some exceptions. For example, income you return as a charitable donation to a religious or nonprofit organization will not be taxed, nor will capital gains from the sale of your primary residence.
Still confused? Use this table as a quick reference for common sources of taxable and nontaxable income for federal tax purposes.
For certain types of income, the answer to whether it is taxable or not is "it depends." For example, alimony payments from divorces prior to 2019 were taxable by the receiving spouse. For divorces finalized on or after January 1, 2019, no tax is payable. Retirement accounts such as IRAs, Roth IRAs, and 401(k)s all have specific rules. Generally speaking, withdrawals from retirement accounts (called required minimum distributions, or RMDs) are taxable.
The big exception is the Roth IRA, which provides tax-free income in retirement.
Read more: 401(k) vs. IRA: The Differences and How to Choose the One That's Right for You
Before you sit down to figure out how much tax you owe, you'll need to gather data on yourself, your spouse, and any dependents. The first is Form W-2, which reflects the traditional wages earned as an employee in box 1 of the form.
If you are self-employed or a contractor and your total income for the year exceeds $600, you may receive a Form 1099-NEC from your business or employer.
This is important before you start crunching the numbers to determine your income tax filing status. Your tax filing status determines your tax bracket and rate as well as the deductions and credits you may be eligible for. These are the filing status options set by the IRS:
Not sure which status is right for you? The IRS has a tax filing status tool that can help you decide the best option for your situation.
Read more: how choose Correct federal tax filing status
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 this number, you can determine your adjusted gross income.
Calculating your adjusted gross income (sometimes called modified adjusted gross income) means making certain adjustments to your total income. Here are some examples:
Work Retirement Plan and IRA Contributions
Alimony
student loan interest
Health Savings Account (HSA) Contributions
Health insurance premiums for self-employed individuals
Your gross income minus these adjustments (also called above-the-line deductions) is your adjusted gross income (AGI).
After calculating your AGI, the final step is to subtract your standard deduction or itemized deductions. The standard deduction is a fixed amount that is subtracted from your adjusted gross income based on your tax filing status.
Itemized deductions are specific items you are eligible to take out, which in some cases may add up to more than the standard deduction. Having a mortgage, large medical bills, or property damage from a federally declared disaster are just a few situations where itemizing deductions may make financial sense.
After subtracting your itemized or standard deductions, the remaining amount is your taxable income. Keep in mind that after calculating this number, you may still qualify for certain tax credits, such as the child tax credit, which may lower your tax liability.
Read more: Standard deduction vs. itemized deductions: How to determine which tax filing method is right
While your federal taxable income is calculated the same way no matter which state you live in, each state has its own income tax rates and guidelines that determine each taxpayer's state tax liability. Fortunately, 31 states (including the District of Columbia) have streamlined the tax filing process by using reported federal adjusted gross income (AGI).
Additionally, some tax filing software can speed up the tax filing process by filing federal and state taxes simultaneously for certain residents.
Reducing your taxable income can reduce the amount of federal income tax you owe. You can achieve better financial planning now and better tax planning next year by using one or more of these strategies.
You can lower your taxable income by increasing your contributions to a traditional 401(k) or traditional IRA. If you are under age 50, you can contribute up to $23,500 before taxes to your employer-sponsored plan for the 2025 tax year. If you're over 50, that number will increase to $31,000 by 2025.
But be aware that not all retirement savings will reduce your tax burden or provide an immediate tax benefit. For example, funding a Roth IRA in U.S. dollars does not reduce your taxable income. However, if a Roth IRA has been open for five years or more, growth is tax-deferred, meaning withdrawals are tax-free in retirement.
Read more: How Much Can You Contribute to a 401(k) in 2025?
Similar to retirement benefits, employer-sponsored health savings accounts (HSAs) and flexible spending accounts (FSAs) use pre-tax dollars to pay for medical expenses and can reduce your taxable income.
In 2025, HSA contribution limits are up to $4,300 for individuals and $8,550 for families. In 2025, the maximum FSA contribution limit is $3,300 for an individual and $6,600 for a married couple to contribute individually to separate FSA accounts.
Read more: What is a Health Savings Account (HSA)?
Taxpayers can also lower their taxes or save by itemizing deductions or using the all-in-one 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 move into a lower tax bracket or avoid paying long-term capital gains taxes through charitable giving, charitable giving, etc. . Qualified charitable distributions, or use of tax-loss harvesting.
High earners and small business owners can especially benefit from professional advice.
Column 1 of the W-2 form you receive from your employer lists your annual income. While this number is a useful starting point for determining your total income, your taxable income may be lower depending on what adjustments, deductions, and tax credits you qualify for.
Interest paid on all student loans, including federal loans, taken out by you, your spouse or on behalf of your dependents is tax deductible. According to the IRS, the maximum deduction per tax year is $2,500, depending on your income qualifications.
If you had your student loans recently forgiven as part of the American Rescue Plan or other federal action, these canceled debts are not taxable.
Read more: Will I be taxed on student loan forgiveness?
While qualified tuition plan or 529 plan contributions will not reduce your taxable income upfront, these tax-advantaged accounts are designed to prepay educational expenses and can be a tax-saving strategy. Income accumulates tax-free, and 529 plan beneficiaries are not required to report account distributions as taxable income.