When tax time rolls around, figuring out which types of income you need to report to Uncle Sam can be confusing. Adjusted gross income, taxable income, investment income, and interest income — all of these have an effect on your tax liability. Understanding what each calculation involves can help you minimize 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, what effect it has on 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 taxes.
Taxable income includes salary or wages from a job and other income sources, such as bonuses and tips, unemployment or disability benefits, and even lottery winnings. The Internal Revenue Service (IRS) requires you to report all amounts “included in your income as taxable unless it is 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 minus deductions (more on that below). The final number is used to determine how much you’ll pay in income taxes on your federal and state income tax returns.
Read more:Expecting money back? Here are 5 smart ways to use your tax refund
According to IRS rules, taxable income is made up of any earned income during the tax year. Here are some basic types of income that the IRS categorizes as taxable and not.
1. Employee compensation
Wages and earnings from your job fall into this bucket, but so do other types of compensation, such as tips, bonuses, and any fees paid to you by an employer. Usually, these earned income sources are reported on your W-2, 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 activity or investments, you’re required to report that as investment or qualified business income. Rental income is a common example, as is interest earned from savings accounts, dividends, or capital gains you realize after selling an asset like a stock.
3. Fringe benefits
Fringe benefits sound like fun, but they’re actually just a term for being tipped, receiving a bonus, or earning extra income for services, either as a salaried or hourly employee or an independent contractor. And you need to account for them on your tax forms.
4. Miscellaneous taxable income sources
There’s a pretty long list of other sources of income the IRS taxes, such as ordinary income from partnerships, S corporations, fair market value of assets earned from bartering, digital currencies, royalties, and more.
Learn more: Yes, crypto is taxed. Here’s when you have to pay.
While it may seem like everything you earn is subject to income tax, there are a few exceptions. For example, earnings that you return as charitable contributions to a religious or nonprofit organization won’t be taxed, nor will capital gains from selling your primary residence.
Still confused? Use this table as a quick reference on common sources of taxable and nontaxable income for federal tax purposes.
With some types of income, the answer to whether it’s taxable is “it depends.”
For example, alimony from divorces finalized before 2019 is taxable for the receiving spouse. For divorces finalized from Jan. 1, 2019, and later, it’s not taxable. And retirement accounts such as IRAs, Roth IRAs, and 401(k)s have specific rules. In general, withdrawals from retirement accounts, known as required minimum distributions (RMDs), are taxable. One big exception is Roth IRAs, which provide tax-free income in retirement.
Read more: 401(k) vs. IRA: The differences and how to choose which is right for you
Before you can sit down and calculate how much tax you owe, you need to gather numbers on yourself, your spouse, and all your dependents. That starts with W-2 forms, which reflect traditional wages earned as an employee in Box 1 of the form.
If you’re self-employed or work as a contractor, you might receive a Form 1099-NEC from a business or employer if your income during the year totaled more than $600.
It’s important before you start running numbers to decide your income tax filing status. Your filing status determines your tax bracket, tax rate, and the deductions and credits you may be eligible for. These are the filing status options set by the IRS:
Not sure which status applies to you? The IRS has a filing status tool that can help you decide the best option for your situation.
Read more: How to choose the right federal tax filing status
Step 3: Calculate your gross income and your 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 have that number nailed down, you can determine your adjusted gross income.
Calculating your adjusted gross income, sometimes referred to as modified adjusted gross income, means making certain adjustments to your gross income. Here are a few examples:
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Deductible IRA contributions
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Retirement contributions
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Student loan interest
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Educator expenses
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Deductible contributions to a health savings account (HSA)
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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 if you’ll take the 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 taken from your adjusted gross income depending on your filing status.
Itemized deductions are specific items you are eligible to deduct that may add up to more than the standard deduction in some situations. Paying interest on a mortgage, having significant medical expenses, or experiencing property loss from a federally declared disaster are just a few scenarios where it may make financial sense to itemize your deductions.
After subtracting your itemized or standard deduction, the remaining amount is your taxable income. Keep in mind that after calculating this number, you may still be eligible for certain tax credits, like the child tax credit, which could lower your tax liability.
Read more: Standard deduction vs. itemized: How to decide which tax filing approach is right
While your federal taxable income will be calculated the same way no matter which state you live in, each state has its own income tax rate and guidelines to determine each taxpayer’s state tax liability. Fortunately, 31 states (including the District of Columbia) have streamlined their tax return process by using the reported federal adjusted gross income.
Additionally, some tax preparation software can expedite the return process by filing federal and state taxes at the same time for some residents.
Reducing your taxable income can reduce the amount of federal income tax you owe. Use these strategies to engage in better financial planning right now and better tax planning next year.
You can lower your taxable income by increasing contributions to a traditional 401(k). If you’re under 50, you can contribute up to $23,500 pre-tax to your employer-sponsored plan during the 2025 tax year. If you’re over 50, that number increases to $31,000 in annual contributions for 2025.
For tax year 2026, you can contribute up to $24,500 with an $8,000 catch-up contribution if you’re over 50.
Note, however, that not all retirement savings will lower your tax burden or provide immediate tax benefits. For instance, a Roth IRA is funded with after-tax dollars and won’t decrease your taxable income. However, if the Roth IRA has been open five years or more, the growth is tax-deferred, meaning your withdrawals in retirement are tax-free.
Read more: How much can you contribute to your 401(k) in 2025?
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.
For tax year 2025, limits for HSA contributions are up to $4,300 individually or $8,550 for families. For those 55 and up, there’s also an extra $1,000 catch-up contribution limit. FSA individual contribution limits are up to a maximum amount of $3,300 in 2025 or $6,600 for married couples contributing individually to separate FSA accounts.
For tax year 2026, the limit is $4,400 for individuals or $8,750 for families (the catch-up contribution for those aged 55 and up is unchanged at $1,000). For an FSA, the contribution limit for tax year 2026 is $3,400 for an individual or $6,800 for married couples contributing individually to separate FSA accounts.
Read more: FSA vs. HSA: Which account is best for you?
Taxpayers can also lower their tax bill or find tax savings by itemizing deductions or using the all-in-one standard deduction.
In some cases, it’s best to consult 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 tax by making charitable donations, a qualified charitable distribution, or using tax-loss harvesting.
High-income earners and small business owners, in particular, may benefit from professional advice.
Read more: What is a financial advisor, and what do they do?
Your annual income is listed in Box 1 of the W-2 form you receive from your employer. While that number is a helpful starting point to determine 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. The maximum deduction, according to the IRS, is $2,500 per tax year, depending on your income eligibility.
Federal student loan forgiveness is not taxable at the federal level through the end of 2025, thanks to the American Rescue Plan Act and programs like the Public Service Loan Forgiveness (PSLF), income-driven repayment (IDR) forgiveness, and others.
Unless Congress extends the exemption, student loan forgiveness will become federally taxable again starting on Jan. 1, 2026.
Learn more: Tax-free student loan forgiveness ends in 2025. Will you owe more?
While a qualified tuition program or 529 plan contributions won’t reduce your taxable income up front, these tax-advantaged accounts are designed to prepay for educational expenses and can be a tax-efficient strategy. Earnings accumulate tax-free, and the beneficiary of a 529 plan doesn’t need to report distributions from the account as taxable income.