As Americans it is a patriotic obligation to pay taxes on income earned. The Internal Revenue Service (IRS) defines income as any money, property, or services received but there are exceptions for both individuals and businesses. Oftentimes, these exceptions come into play when certain circumstances arise. Knowing these exceptions can also be important in financial planning and investing as well since they can offer some performance return advantages. This article highlights a few of the top sources for nontaxable income primarily in the realm of personal finance.
1. Disability Insurance Payments
Usually, disability benefits are taxable if they come from a policy with premiums that were paid by your employer. However, there are some 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). Employer-provided long-term care insurance is also not taxable.
3. Health Savings Accounts
Also in the medical benefits category, distributions from health savings account are not taxable. Health savings accounts are only available to individuals enrolled in a high-deductible health plan (HDHP) which limits their use.
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 can be some exceptions to this rule. Also, if you cash in or convert a life insurance plan it may have some tax obligations.
5. Income Earned in Seven States
In the U.S., 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, seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) have chosen to not levy a state income tax on their residents. (Not surprisingly, that makes some states popular with retirees, though other factors, such as whether pensions and Social Security payments are taxed and the cost of living, are also factors.) Two states, Tennessee and New Hampshire, tax only dividend and interest income.
6. Corporate Income Earned in Four States
Corporations certainly enjoy tax exemptions as well, and a lack of state income tax can also encourage corporations to locate there. There are no corporate taxes in Nevada, Ohio, Texas, Washington, South Dakota, and Wyoming, according to the Tax Foundation. However, Nevada, Ohio, Texas, and Washington, impose gross receipts taxes.
7. 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.
8. Gift Giving of up to $15,000 and Gift Receipts of Any Amount
The IRS does not tax gifts received. Gift givers are liable for gifts of over $15,000. If gifting over $15,000 the excess amount can be counted toward a lifetime gift exemption of $10 million. This eliminates any gift taxes for most people, but if gift taxes must be paid they range from 18% to 40% for the gift giver.
$15,000 is generally the maximum gifting amount for gift tax exemption and any taxes are only paid by the gift giver.
Note that prizes are not the same as gifts. You do generally have to pay taxes on a prize. In some cases prizes may also include services received which are then subject to fair market value tax reporting.
Additionally, the following types of income are considered fully 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 the giver's taxable income by the amount of the donation if they itemize their deductions instead of taking the standard deduction
An important exception to this rule is gifts from employers. These gifts are usually considered fringe benefits, not gifts, and are taxable income. A small gift worth less than $25, such as a holiday fruitcake, is an exception to the fringe benefit rule.
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 to someone at less than its market value, the IRS may consider it a gift.
Overall, an accountant can provide you with tax-planning advice to help you avoid any gift taxes. The IRS requires IRS Form 709 when gift taxes apply.
The estate tax exemption doubled as part of the Tax Cuts and Jobs Act of 2017. In 2018, that figure was supposed to rise to $5.6 million for individuals, double for couples. But the new tax bill brought that individual exemption to $11.2 million, with couples at $22.4 million, a break that will last until 2026. Any amount over the exemption is subject to tax.
10. Municipal Bond Interest
Municipal bonds are one of the most popular tax-free investments. 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 invest in and 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 in which the bonds were issued. 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 32% to 37% federal income tax brackets.
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. 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 2018, you could subtract $3,000 from your taxable income on your 2018 tax return and $1,500 from your income on your 2019 tax return.
12. Retirement Income
Retirement account investing offers a number of tax advantages. In retirement, all income from Roth IRAs is nontaxable. Roth IRAs also offer the advantage of nontaxable income before age 59.5 if the account has been held for five years.
The Bottom Line
Americans should be aware of the tax obligations on any income received throughout the taxable year since the government requires a stake to all types of income in most cases. There are, however, many exceptions. Knowing the exceptions and special circumstances that eliminate the need for tax payments can be important in all types of financial decisions.
Why has the IRS chosen to make exemptions for income when it generally tries to tax everything? Reasons include the belief that eliminating or dramatically reducing taxes in certain areas will encourage certain activities thought to benefit the country, such as home ownership and investment, and reduce the risks associated with these activities. In addition, some exemptions are targeted to people in need, such as those receiving certain categories of disability payments.
Each year the IRS updates Publication 525 which details taxable and nontaxable income. Citizens can see this publication for more clarification and questions on various types of nontaxable income.