Paying taxes is a fact of life for most Americans. Whether you work for a business from 9 to 5 or you’re self-employed, you’re expected to turn over a portion of your pay to Uncle Sam. There are many different kinds of income, but not all of them can be taxed. Read on for an explanation of what taxable income is and a rundown of what’s taxable and what’s not.
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Taxable Income: The Basics
Taxable income is essentially any money someone has received that’s subject to income tax. It’s calculated by taking your gross income (the total amount of money that you’ve gotten from any source of income during a tax year) and subtracting any deductions and exemptions that you can claim. Taxable income differs from adjusted gross income, which is your gross income minus all of your above-the-line tax deductions.
While there are multiple types of income, they can be divided into two broad categories: earned income and unearned income. Earned income – or the money you make from running your own company or working as an employee – is usually taxable. Everything you earn is subject to income tax and payroll taxes (for Medicare and Social Security). Unearned income, on the other hand, may or may not be taxable.
Taxable Earned Income
Examples of earned income that can be taxed include salaries, wages, commissions and any tips you receive from working at a restaurant or another business in the service industry. Other forms of employee compensation – including paid time off, stipends and sick pay – are considered both earned income and taxable income.
Self-employment income, rental income, long-term disability benefits (prior to the minimum retirement age) and union strike benefits are taxable. The pay you receive from serving on a jury is subject to income tax, too. Usually, this money gets turned over to a worker’s employer. But the employee can get a tax deduction for the full amount of jury duty pay. This is an above-the-line deduction that you can claim on your tax return regardless of whether you’re itemizing your deductions or taking the standard deduction.
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Unearned Income That’s Taxable
Many forms of unearned income are taxable. Unemployment benefits, alimony and gambling and contest winnings are all examples of unearned income that can be taxed. Other types of unearned income that can raise your income tax bill include dividends, any interest you earn from investing and capital gains.
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If some of your debt has been forgiven, it’s generally taxable unless it was discharged through insolvency or bankruptcy. Life insurance proceeds are taxable as well if you exchange them for cash and take more money than the original policy amount.
If you receive Social Security, part of your monthly checks may be taxable. That may happen if you’re retired, your income comes from more than one source and the amount of money you’re receiving is higher than a certain threshold. If you have multiple streams of income, up to 85% of your Social Security benefits may be taxed.
Unearned Income That’s Not Taxable Income
Unlike earned income, unearned income is never subject to payroll taxes. You won’t have to pay income taxes either (in most cases) if you have welfare benefits, you’re making child support payments or you’re receiving workers compensation benefits. Tax refunds, personal injury rewards and gifts generally aren’t taxable either (unless the gift itself generates income).
Scholarships aren’t considered taxable income unless you’re using the funds to cover the cost of certain expenses (like room and board). Inherited assets aren’t taxable unless the original owner would have had to pay income taxes. For example, if you inherited a 401(k), you’ll owe income taxes when you begin withdrawing money from the account.
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If you have multiple sources of income, it’s important to know which kinds of income are taxable. Understanding how taxable income works is key if you don’t want to get busted for failing to claim some of your earned or unearned funds.
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