The Internal Revenue Service defines income as any money, property or services you receive - and Uncle Sam wants a bite of practically everything. The government says that all types of income are taxable unless specifically excluded by law. This article will describe a few of the more common categories of nontaxable income.

Income That Isn't Taxed

1. Disability Insurance Payments
Usually, disability benefits are taxable if they come from a policy with premiums that were paid by your employers. However, there are many other categories of disability benefits that are nontaxable.

  • If you purchase supplemental disability insurance through your employer with after-tax dollars, any benefits you receive from that plan are not taxable.
  • If you purchase a private disability insurance plan on your own with after-tax dollars, any benefits you receive from that plan are not taxable.
  • Workers' compensation (the pay you receive when you are unable to work because of a work-related injury) is another type of disability benefit that is not taxable.
  • Compensatory (but not punitive) damages for physical injury or physical sickness, compensation for the permanent loss or loss of use of a part or function of your body, and compensation for your permanent disfigurement are not taxable.
  • Disability benefits from a public welfare fund are not taxable.
  • Disability benefits under a no-fault car insurance policy for loss of income or earning capacity as a result of injuries are also not taxable

2. Employer-Provided Insurance
The IRS says that "generally, the value of accident or health plan coverage provided to you by your employer is not included in your income." This could be health insurance provided through your employer by a third party (like Aetna or Blue Cross) or coverage and reimbursements for medical care provided through a health reimbursement arrangement (HRA). Furthermore, employer and employee contributions to a health savings account are not taxable. Employer-provided long-term care insurance and Archer MSA contributions (a type of medical savings account) are also not taxable.

3. Gift Giving of Up-to $13,000; Gift Receipt of Any Amount
Just as the IRS defines all income as taxable, except that which is specifically excluded by law, it defines all gifts as taxable, except those specifically excluded by law. Thankfully, there are many gifts that aren't taxable, and any tax due is always paid by the gift-giver, not the recipient. (Note that a prize is not the same as a gift. Read Winning The Jackpot: Dream Or Financial Nightmare? to learn more.)

Perhaps the most well-known exclusion is that individuals can gift up to a certain amount per donor per year without the gift being taxable. For example, each member of a married couple could give each of their three children $13,000 in 2010 and 2011. The parents would gift a total of $78,000, and none of that gift would be taxable for either the parents or the children. Each child would receive $26,000 of nontaxable income.

The following types of income are also considered nontaxable gifts:

  • Tuition or medical expenses paid on someone else's behalf
  • Political donations
  • Gifts to charities (charitable donations) - in fact, these are tax-deductible, meaning that they reduce your taxable income by the amount of the donation. (Learn more in It Is Better To Give AND Receive.)

An important exception to this rule is gifts from employers. These gifts are usually considered fringe benefits, not gifts, and are taxable. A small gift worth less than $25, such as a holiday fruitcake, is an exception to the fringe benefit rule. (You might want to check out Top 7 Estate Planning Mistakes.)

To prevent tax evasion, the IRS also says that the gift tax applies "whether the donor intends the transfer to be a gift or not." For example, if you sell something at less than its market value, the IRS may consider it a gift. An accountant can provide you with tax-planning advice to help you avoid triggering the gift tax and let you know when you should file IRS form 709, United States Gift (and Generation-Skipping Transfer) Tax Return.

4. Life Insurance Payouts
If a loved one dies and leaves you a large life insurance benefit, this income is generally not taxable. However, be aware that there are some exceptions to this rule in more complex situations. IRS publication 525: Taxable and Nontaxable income, describes these exceptions.

5. Sale of Principal Residence
Individuals and married couples who meet the IRS's ownership and use tests, meaning that they have owned their home for at least two of the last five years and have lived in it as a principal residence for at least two of the last five years, can exclude from their income up to $250,000 (for individuals) or $500,000 (for married couples filing jointly) of capital gains from the sale of the home.

6. Up to $3,000 of Income Offset by Capital Losses
If you sell investments at a loss, you can use your loss to reduce your taxable income by up to $3,000 a year. Capital losses can even be carried over from year to year until the entire loss has been offset. For example, if you sold investments at a loss of $4,500 in 2011, you could subtract $3,000 from your taxable income on your 2011 tax return and $1,500 from your income on your 2012 tax return.

7. Income Earned in Nine States
Under the U.S.'s federalist system, each state is able to make many of its own laws. So even though most income is taxable at the federal level, and most states also levy a state tax on income, nine states - Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming (as of 2009) - have chosen to not levy a state income tax on their residents. This tax break encourages people to vote with their feet and move to these states where they will be able to keep more of their income. (Which states are tax-effective retirement locales? It depends on the source of your retirement income, read Finding A Retirement-Friendly State.)

8. Corporate Income Earned In Five States
Some states also encourage corporations to locate there by not taxing corporate income. There are no corporate taxes in Nevada, South Dakota, Texas, Washington and Wyoming. This tax break can encourage businesses to locate in these states, which in turn can help improve the overall economic climate in these states.

9. Inheritance
The estate tax, also known as the death tax, seems to always be in flux. This tax tends to unfairly penalize the beneficiaries of the wealthy, as estates with values of up to a couple million are usually exempt from the estate tax. Here are the estate tax levels from 2005 to 2011:

Year Amount Exempt from Estate Tax Estate Tax Rate on Amount Exceeding Exemption
2005 $1.5 million 47 %
2006 $2 million 46 %
2007 $2 million 46 %
2008 $2 million 46 %
2009 $3.5 million 45 %
2010 unlimited 35 %
2011 $5 million 35%

While the estate tax technically falls on the estate, it really affects the beneficiaries of the estate. But if you are the beneficiary of an estate that falls into the exempt category, you'll get all that income, tax free. And if you inherit an estate worth more than the exemption, you'll still get the exempt amount tax free.

10. Municipal Bond Interest
Most of the time, when you invest in bonds, you have to pay federal, state and/or local tax on the yield you earn. However, when you earn money from municipal bonds, the proceeds are usually tax-free at the federal level and also tax-free at the state level if you live in the same state the bonds were issued in. This tax exemption applies whether you invest in individual municipal bonds or purchase them through a municipal bond fund.

Although municipal bonds generally offer a lower rate of return than other types of bonds, when you consider their after-tax return, you may end up ahead by investing in municipal bonds. Municipal bonds are generally recommended only for higher-income individuals and married couples who fall into the 28-35% federal income-tax brackets. (Investing in these bonds may offer a tax-free income stream but they are not without risks, see The Basics Of Municipal Bonds.)

Conclusion: Arbitrary Taxation
Taxes discourage all activities that are taxed, so why has the IRS chosen to exempt these and a few other sources of income when it generally tries to tax everything? The answer to this question varies, depending on your political views, but for whatever reason, the government has decided to eliminate or dramatically reduce taxes in certain areas to encourage certain activities that it thinks will benefit the country, such as home ownership and investment, and reduce the risks associated with these activities. Why the government taxes the income you earn at work, but not life insurance, is anyone's guess. (Learn the logic behind the belief that a reducing government income benefits everyone, read Do Tax Cuts Stimulate The Economy?)

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