Financial Jargon Defined: Taxable Income

The world of finance and investments is notorious for its extensive use of jargon. With a goal of enhancing financial literacy and making the world of money more transparent, we have our “monthly jargon” post that focuses on debunking financial terms that are continuously used sans explanation. This month, we are addressing a year-end term that doubles as a reminder to review your finances before December 31 comes and goes: “taxable income.” There are many different types of income: active income, passive income, gross income, taxable income, ordinary income, adjusted gross income (AGI), to name a few. When we use the term “taxable income,” we are speaking to the amount of income used to calculate how much tax an individual or a company owes to the government for a given tax year. Taxable income refers to one’s adjusted gross income (AGI) minus any deductions or exemptions permitted in a specific tax year. Although similar, when it comes to taxes, the Internal Revenue Service (IRS) distinguishes between an individual’s AGI and taxable income.

Let’s quickly define gross income and adjusted gross income (AGI) to fully understand how taxable income is calculated. Gross income can be thought of as gross pay and is a sum of a person’s total compensation from an employer (or employers if the individual has more than one means of employment) and any additional money earned and accrued in a year before taxes. Adjusted gross income (AGI) is one’s gross income after making “adjustments” that involve taking out allowable deductions like certain retirement plan contributions and health savings account (HSA) deductions. To tie these three terms together, taxable income is calculated by taking gross income (all money made subject to income taxes) and subtracting the adjustments to determine AGI, and lastly subtracting personal exemptions and either the standard or applicable itemized deductions to calculate taxable income. That being said, AGI is a more useful number for tax purposes than gross income and put simply, one’s taxable income is the amount used to calculate how much an individual owes in income taxes.

When determining your gross income, wages, salaries, bonuses, tips, investment income, and unearned income from investments and sources unrelated to employment (such as interest accrued from savings accounts and dividends from stocks) are all included. When filing your taxes and determining your taxable income, you can either claim the standard deduction or itemize your deductions. An individual’s standard deduction is determined on filing status, age, and whether someone is disabled or claimed as a dependent. Itemized deductions are expenses on certain products and contributions that can be subtracted from your AGI to reduce your taxable income and thus your tax bill. People choose to go the itemization route because doing so may allow them to reduce their taxable incomes by more than the standard deduction would, as the standard deduction is merely a fixed dollar amount. If you use an online tax preparation software like TurboTax, the program will do all of these calculations for you.

The name of the game is determining how to get your taxable income to be as low as possible because the lower your taxable income, the lower the taxes you owe will be. Taking actions to reduce your taxable income is important to remember as yearend approaches because once the year comes to a close, you are locked into that taxable income amount come tax time. A few year-end tax tips to reduce your taxable income: maximize retirement savings by maxing out your 401(k) and individual retirement account (IRA) contributions, leverage a flexible spending account (FSA), max out your health savings account (HSA) if you have a high deductible health insurance plan, and consider selling losing positions in a taxable investment account to offset your account gains. The end of the year is a great time to evaluate your financial life and ensure you take the necessary year-end actions to lower your taxable income to keep more of your hard-earned cash in your pockets come April.