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, interest income — all of these terms have an effect on your tax liability. And understanding what each calculation involves can help you minimize what you owe when it comes time to pay taxes.

Let’s take a closer look at what is considered taxable income, how to calculate taxable income, and what effect taxable income has on your tax rate, federal tax return, and state income taxes.

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Taxable income explained

In the simplest terms, taxable income is a calculation of both your earned and unearned income that is used to determine how much you’ll pay in income taxes on your federal and state income tax returns. Taxable income includes wages or a salary from a job and other income sources such as bonuses and tips, unemployment or disability benefits, savings account interest, and even lottery winnings. Depending on your overall income level, a portion of your Social Security benefits could be taxable.

Calculating taxable income involves determining your adjusted gross income minus whatever you itemize in deductions or a standard deduction. The Internal Revenue Service (IRS) requires you to report all amounts “included in your income as taxable unless it is specifically exempted by law.”

Read more: Expecting money back? Here are 5 smart ways to use your tax refund

What's the difference between taxable and nontaxable income?

According to IRS rules, taxable income is made up of any earned income during the tax year. Here are some basic categories of income that the IRS categorizes as taxable.

Common sources of taxable income

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 taxable sources are reported on your W2, 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 of this type of taxable income.

3. Fringe benefits

Fringe benefits sound like fun, but they’re actually just a term for being tipped, providing 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 laundry list of other sources of income the IRS taxes such as income from partnerships, S corporations, fair market value of assets earned from bartering, digital currencies, royalties, and more.

Common sources of nontaxable income

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.

How to calculate your taxable income in 3 easy steps

Determining your taxable income can help you save for how much tax you owe, give you the ability to adjust your deductions, and glean insight into whether you’ll land in a higher tax bracket than last year.

Step 1: Gather documentation of your income

Before you can sit down and calculate how much taxes 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.

Step 2: Determine your filing status

It’s important before you start running numbers to decide your individual income tax filing status. These are the filing status options set by the IRS:

• Single

• Head of household

• Married filing separately

• Married filing jointly

• Qualifying widow(er)

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.

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, also sometimes referred to as modified adjusted gross income, means making certain deductions from your gross income. Here are a few deductions the IRS allows you to subtract from your income:

• Contributions to an individual retirement account (IRA) or employer retirement plan

• Mortgage interest

• Student loan interest

• Some other expenses related to education

• Contributions to a health saving accounts (HSA)

• Health insurance premiums for the self-employed

Your gross income minus deductions is your adjusted gross income — aka your taxable income. Once you have your taxable income calculated, you’ll be able to clearly see what tax bracket you land in.

Frequently asked questions

1. Is taxable income listed on my W2?

Income is usually listed in Box 1 of the W2 form you receive from an employer. While that number is a helpful starting point to determine gross income, your adjusted gross income or taxable income may be lower depending on the deductions and tax credits you qualify for.

2. How do I reduce my taxable income?

Reducing your taxable income can reduce the amount of federal income tax you owe. You can do that by making contributions to retirement accounts and health savings accounts that cover medical expenses. Conversely, taxpayers can also lower their tax bill by taking itemized deductions or the all-in-one standard deduction available to filers depending on their status.

3. Is student loan interest deductible?

Tax deductions are allowed for interest paid on all student loans, including federal loans, taken out by yourself, your spouse, or on behalf of your dependents. The maximum deduction according to the IRS is $2,500 per tax year.

If you’ve recently had your student loans forgiven as part of the American Rescue Plan or another federal action, those canceled debts are also not taxable.

Read more: What else to know about taxes on cancelled student debt