They may sound similar, but it’s critical to understand the difference between gross income and taxable income. While gross income encompasses all the money you earn from various sources throughout the year, your taxable income comprises only the portion of your gross income that’s subject to taxes after deductions. A financial advisor can help you organize your finances and potentially optimize your tax strategy.
What Is Gross Income?
Gross income is the total income earned or received before taxes and other deductions. Essentially, gross income represents the entirety of your pre-tax earnings. It not only includes your salary or wages but also income from investments, rental properties, business profits and any other sources that are not tax-exempt.
Understanding your gross income is the first step in financial planning and tax preparation, as it serves as the starting point for calculating your adjusted gross income, and ultimately, your taxable income.
For example, a worker earns a full-time base salary of $75,000 as a sales associate for a software company. On top of this salary, the worker receives $35,000 in commissions and bonuses, bringing a total income to $110,000. However, the worker also pockets $2,000 per year in dividends that a stock portfolio generates.
After adding up the different ways the worker makes money, the gross income for the year comes to $112,000. We’ll use this example later on to calculate taxable income.
What Is Taxable Income?
While gross income is the sum of all of the money you earn or receive in a year, you won’t necessarily pay taxes on all of it. Taxable income is the portion of your gross income that the government deems subject to taxes at both federal and state levels.
Your taxable income is what’s left over after certain deductions and exemptions are applied. These deductions can significantly reduce the amount of income that Uncle Sam ultimately taxes, thus lowering your overall tax liability.
For example, the same worker from before saves $6,500 in a traditional IRA. These contributions will ultimately reduce the taxable income by $6,500. Pre-tax IRA contributions savings are known as “above-the-line” deductions or adjustments, which may also include student loan interest and some education expenses, health savings account (HSA) contributions and business expenses, among others. However, keep in mind that contributions made to a pre-tax 401(k) aren’t considered above-the-line deductions, but they also lower your taxable income.
How to Calculate Your Taxable Income
Determining your taxable income starts with calculating AGI, which is essentially your gross income minus any above-the-line adjustments.
In the earlier example, the worker’s AGI would be $105,500 after contributing $6,500 to an IRA. Of course, by paying student loan interest or contributing to an HSA, these transactions could further reduce that AGI.
However, AGI is not the same as taxable income. From there, you’ll need to subtract the standard deduction or the sum of all of your itemized deductions. The result is your taxable income.
Standard Deduction vs. Itemized Deductions
When it comes to reducing your taxable income and potentially lowering your tax bill, you have two main options: taking the standard deduction or itemizing your deductions.
The standard deduction is a flat amount that the tax system lets you deduct, no questions asked. For the tax year 2023, the standard deduction is $13,850 for singles and married persons filing separate returns, $27,700 for married couples filing jointly and $20,800 for heads of households. This deduction is subtracted from your AGI to calculate your taxable income.
Itemized deductions, on the other hand, are specific expenses that can be subtracted from your AGI to reduce your taxable income. Examples include mortgage interest, property taxes, medical expenses and charitable donations. You can also deduct up to $10,000 in state and local taxes if you itemize.
To make a choice between the standard deduction and itemized deductions, you’ll need to determine which method will deduct more from the income and produce a lower taxable income. If your itemized deductions total more than your standard deduction, you would choose to itemize. Conversely, if your standard deduction is higher than your itemized deductions, you would choose the standard deduction.
If our hypothetical worker takes the standard deduction as a single tax filer, this would simply subtract $13,850 from the AGI of $105,500. That come out to a taxable income of $91,650 and put the worker in the 24% federal tax bracket in 2023.
Then again, if itemized deductions added up to $15,000, for example, the worker would forgo the standard deduction and itemize instead. That come out to a taxable income of $90,500.
Bottom Line
Understanding the distinctions of gross income vs. taxable income is central to accurate financial planning and tax preparation. While gross income represents the total amount you earn before deductions and taxes, taxable income is the portion that’s ultimately subject to taxation. To accurately calculate your tax liability, you’ll need to grasp both concepts.
Tax Filing Tips
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