We all know that taxes are a part of life. But what may catch some of us off-guard is the fact that the IRS is entitled to a piece of the money we earn even when it's not derived from a job.
What is taxable income?
Taxable income is income the IRS can tax you on. When we hear taxable income, we generally think of wages from a job or freelance work. After all, you're going out, working, and earning money. The IRS' reach actually extends much further. Here are some additional income sources you can be taxed on:
- Interest income, whether from a savings account or bonds
- Dividend income
- Investment income, like short-term and long-term capital gains
- Rental income from a property you own
- Capital gains on the sale of a home (though there's an exemption that applies first)
- Unemployment benefits
- Severance pay
- Lottery winnings and other prizes
- Gambling winnings
- Alimony for agreements entered before 2019
- Jury duty fees
- Pension payments (though there are exceptions)
- Social Security benefits (there are exceptions for lower-income seniors)
- Traditional retirement plan withdrawals
- Settled debts where a portion of what you owe is forgiven (there are exceptions for bankruptcy filings)
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Of course, not all income is taxed equally. Your wages are subject to your ordinary income tax rate, and that depends on the tax bracket you fall into. The same holds true for interest income and short-term capital gains, which apply to investments held for a year or less. Long-term capital gains (those that apply to investments held for at least a year and a day) and qualified dividends are taxed at a lower, more favorable rate than ordinary income.
When you file your annual tax return, you must declare all of the above types of income. Additionally, if you receive a large amount of taxable income during the year outside of a paycheck from work, you'll need to pay estimated quarterly taxes on it to the IRS. If you ignore those quarterly payments and instead catch up when you file your tax return, you could be hit with penalties. Remember, our tax system is "pay as you go." The IRS doesn't take kindly to having to wait to get its money (though it has no problem hanging onto taxpayers' money during the year and then returning it in refund form later on).
What income isn't taxable?
While much of the income you'll earn or collect is subject to taxes, there are a number of exceptions. The following income sources aren't considered taxable:
- Child support payments
- Alimony payments for agreements entered into after Dec. 31, 2018
- Scholarships
- Foster care payments
- Death benefits from a life insurance policy
- Personal injury awards
- Workers compensation
- Disability benefits if you paid for the policy
- Canceled debts from a bankruptcy
- Municipal bond interest (though state taxes can apply)
- Roth IRA and 401(k) withdrawals
If you're not sure what income of yours is taxable, consult an accountant. Don't get penalized for accidentally failing to report income to the IRS.
How to reduce your taxable income
The less taxable income you have to report, the less you pay the IRS. There are a number of legal ways you can reduce your taxable income:
- Max out contributions for a traditional IRA or 401(k)
- Max out a health savings account (HSA)
- Contribute to a flexible spending account (FSA)
- Sign up for commuter benefits through your employer
- Hold investments for at least a year and a day before selling them
- Sell losing investments to offset capital gains (and, in some cases, ordinary income as well)
- Be smart about claiming tax credits and deductions
Paying taxes is necessary. Knowing what income source you'll be taxed on can help you better prepare and avoid unpleasant surprises.
