How the IRS computes taxable income — at a glance

The IRS determines taxable income in a clear sequence: start with gross income, remove exclusions, apply adjustments (to arrive at adjusted gross income or AGI), subtract either the standard deduction or itemized deductions, and then apply any special deductions such as the qualified business income (QBI) deduction. What remains is your taxable income, which the tax tables then use to determine tax before credits.

Step-by-step: How taxable income is calculated

  1. Gross income: Add all income from every source — wages, self-employment receipts, interest, dividends, rental income, and gross capital gains. (IRS guidance treats some items differently; see IRS Pub. 17.)

  2. Remove excluded income: Subtract amounts the code excludes from gross income (common examples: certain gifts, life insurance proceeds received on the death of the insured, and some municipal bond interest). Exclusions reduce gross income before any deductions.

  3. Apply adjustments to income (above-the-line deductions): Subtract allowable adjustments to determine AGI. Typical adjustments include contributions to traditional IRAs (when deductible), HSA contributions, student loan interest, educator expenses, and the self-employed health insurance deduction. These are listed on Form 1040 and supported by IRS guidance.

  4. Subtract deductions: Choose either the standard deduction or itemize eligible expenses (medical expenses above the AGI threshold, mortgage interest, state and local taxes up to current limits, charitable gifts where applicable). The standard deduction amounts change annually — see IRS guidance and our article on the Standard Deduction for details. Standard Deduction Standard Deduction vs. Itemized Deductions

  5. Apply special deductions: After AGI and the standard/itemized choice, apply tax code provisions such as the Qualified Business Income (QBI) deduction for pass-through businesses (Section 199A), if eligible.

  6. Result — taxable income: The final figure after the above steps is your taxable income. Tax rates (including special rates for long-term capital gains and qualified dividends) are then applied to compute tax before credits.

A practical example (hypothetical)

  • Gross income: $90,000 (wages + freelance income)
  • Exclusions: $1,000 in municipal bond interest (not taxable)
  • Adjustments: $6,500 deductible IRA contribution + $3,000 HSA contribution = $9,500
  • AGI: $90,000 – $1,000 – $9,500 = $79,500
  • Deductions: standard deduction (use the current year amount) or itemized total of $11,000. If standard deduction is larger, subtract that instead.
  • Taxable income: AGI – deduction = final taxable income (this is the amount taxed).

Note: This example uses round, hypothetical amounts to illustrate the mechanics. Actual deduction limits and eligibility rules change; consult the IRS or a qualified tax professional for exact calculations.

Key exclusions and common adjustments (what to watch for)

  • Common exclusions: municipal bond interest, certain employer-paid fringe benefits, and qualified distributions of some life insurance proceeds. (IRS rules specify these in detail.)
  • Typical above-the-line adjustments: deductible traditional IRA contributions (subject to income limits), HSA contributions, student loan interest deduction (income-limited), educator expenses, and self-employed retirement plan contributions.
  • Deductions vs. credits: Remember that deductions lower taxable income; tax credits reduce tax owed dollar for dollar. Don’t conflate the two.

Practical tax-planning tips (based on professional experience)

  • Maximize pretax retirement and HSA contributions early in the year to reduce AGI and potential phase-outs tied to AGI. In my practice, moving a few hundred dollars of contributions earlier in the year sometimes prevents the loss of a credit or deduction.
  • Bunch itemizable expenses (charitable gifts, medical expenses) into one year when you’re close to the standard deduction threshold. See our guide on choosing between itemizing and the standard deduction. Choosing Between Itemizing and the Standard Deduction in 2025
  • Be mindful of the timing of capital gains and losses; harvesting losses in a high-income year can lower AGI and taxable income.
  • For business owners, track eligible Section 162 ordinary and necessary business deductions and consult on QBI eligibility — misclassifying personal expenses as business expenses is a frequent audit trigger.

Common mistakes taxpayers make

  • Treating tax-exempt income as taxable (e.g., municipal bond interest) or forgetting to report taxable retirement distributions.
  • Mixing up deductions and credits when planning — credits often provide larger tax savings than deductions.
  • Missing above-the-line deductions because of poor recordkeeping (some adjustments require receipts or plan statements).

Recordkeeping checklist

  • W-2s and 1099s for all income sources
  • Form 5498 and IRA contribution records
  • HSA contribution and distribution reports (Form 5498-SA / 1099-SA) if applicable
  • Receipts for charitable contributions and eligible medical expenses
  • Business records for self-employed taxpayers (invoices, mileage logs, expense receipts)

Authoritative sources and further reading

  • Internal Revenue Service, Publication 17 and Form 1040 instructions (IRS.gov).
  • IRS Topic pages on Adjusted Gross Income and Exclusions from Income (IRS.gov).
  • Consumer Financial Protection Bureau, Tax preparation resources.

Professional disclaimer

This article is educational and does not replace personalized tax advice. Tax law changes, limits, and phase-outs can vary by year and by taxpayer. Consult a qualified tax professional or the IRS for guidance tailored to your situation.