Most of the income you earn through work or investments is subject to federal income tax and, in some cases, to state taxes, as well. But there are certain categories of income that are exempt from income tax. Here are 12 that every taxpayer should know about.
- Most of your income is probably taxable, but federal and state tax laws provide some exceptions.
- States differ in how they tax income, and some have no income tax at all.
- Certain investments can also provide tax-free income, including interest on municipal bonds and the income realized on contributions in Roth retirement accounts.
1. Disability Insurance Payments
Disability benefits are taxable if your employer paid the premiums for the policy. However, there are some categories of disability benefits that are nontaxable:
- Any benefits you receive from supplemental disability insurance you purchased through your employer with your own after-tax dollars.
- Any benefits you receive from a private disability insurance plan you purchased with after-tax dollars.
- Workers' compensation payments.
- 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, or compensation for permanent disfigurement.
- Disability benefits from a public welfare fund.
- Disability benefits under a no-fault car insurance policy for loss of income or earning capacity as a result of injuries.
2. Employer-Provided Insurance
The IRS says that "in most cases, 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 by your employer through a third party (like Aetna or Blue Cross) or coverage and reimbursement for medical care provided through a health reimbursement arrangement (HRA). Employer-provided long-term care insurance is also not taxable.
In addition, an employee does not pay tax on the cost of up to $50,000 of group-term life insurance provided by an employer. However, if the employer pays the cost of more than $50,000 of such insurance, the cost of the excess coverage, less any amount paid by the employee, is taxable to the employee.
3. Health Savings Accounts (HSAs)
Also in the medical benefits category, distributions from a health savings account (HSA) are not taxable, as long as they are used for qualified expenses. Health savings accounts are only available to individuals enrolled in a high-deductible health insurance plan.
4. Life Insurance Payouts
If a loved one dies and leaves you a life insurance benefit, this income is generally not taxable. However, there can be some exceptions to this rule. Also, if you cash in or convert a life insurance policy you own, there may be some tax implications.
5. Earned Income in Seven States
States vary in the kinds of income they tax and the rates at which they tax it. Seven states—Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming—have no income tax at all. New Hampshire and Tennessee tax only interest income and dividends, not earned income from salary and wages. (Tennessee is scheduled to repeal that tax for tax years beginning on or after January 1, 2021). Some states also exempt pension and Social Security income from taxation, although both are taxed on the federal level.
6. Corporate Income Earned in Six States
There are no corporate income taxes in six states—Nevada, Ohio, Texas, Washington, South Dakota, and Wyoming—according to the Tax Foundation. However, Nevada, Ohio, Texas, and Washington do impose taxes on a corporation's gross receipts. Two states—South Dakota and Wyoming—tax neither.
7. Sale of a 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 when they sell the home.
8. Financial Gifts
Under IRS rules, the giver of a financial gift, rather than the recipient, may be subject to gift taxes. Currently, gifts of up to $15,000 per recipient per year are exempt from taxes. This is true for tax years 2020 and 2021. Couples who make gifts can double that amount, to $30,000. While the recipients won't owe income or gift taxes on the gift itself, any income that the gift produces (such as stock dividends) is taxable.
Financial gifts generally aren't treated as income, although the giver may owe gift tax if they're over $15,000.
Additionally, the following types of gifts are considered fully nontaxable:
- Tuition or medical expenses paid on someone else's behalf.
- Political donations.
- Gifts to charities. Unlike other types of gifts, charitable donations are also tax-deductible. Note that there are special rules for 2020.
- An important exception to this rule is financial gifts from employers, such as cash or gift cards. These are usually considered fringe benefits, not gifts, and are treated as taxable income. However, a gift of modest value, given infrequently, such as a holiday fruitcake, is considered a de minimis benefit and not taxed.
Inheritances are not considered taxable income. However, estates over a certain size may be subject to estate taxes, which are paid by the estate itself. The amount that's not subject to tax, known as the estate tax exemption, is $11.58 million for individuals, doubling to $23.16 million for couples (as of 2020). For 2021, the estate tax exemption rises to $11.7 million. Any amount over the exemption is subject to tax.
10. Municipal Bond Interest
Most of the time, when you invest in bonds, you have to pay federal and state taxes on the income you receive from them. One exception is municipal bonds, issued by states and other government entities. Their income is generally tax-free on the federal level and also at the state and local level if you live in the state where the bonds were issued. This tax exemption applies whether you invest in individual municipal bonds or buy them through a municipal bond fund or ETF. Interest income from US Treasury bills, notes, and bonds is subject to federal income tax but exempt from state and local income taxes.
Municipal bonds generally pay less than other types of bonds. But, depending on your tax bracket, they may offer a better after-tax return than their taxable counterparts.
11. 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. What's more, capital losses can 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 2020, you could subtract $3,000 from your taxable income on your 2020 tax return and the remaining $1,500 from your income on your 2021 tax return.
12. Roth Retirement Account Income
Qualified retirement accounts, such as 401(k) and 403(b) plans and IRAs, offer a number of tax advantages, including deferring any tax on your investment income and gains until you withdraw the money. In the case of Roth 401(k)s, Roth 403(b)s, and Roth IRAs, the money you withdraw is not taxable at all as long as you meet the rules on Roths.
The IRS provides further information on taxable and nontaxable income in its annually updated Publication 525.