What is Exempt Income?

Exempt income refers to certain types or amounts of income not subject to federal income tax. Some types of income may also be exempt from state income tax. The IRS determines which types of income are exempt from federal income tax as well as the circumstances for each. Congressional action plays a role as well, as what is exempted and the threshold amounts are often tweaked or changed entirely.

Understanding Exempt Income

Exempt income rules underwent certain changes under the Tax Cuts and Jobs Act signed into law in December 2017. For example, the Act eliminated personal exemptions from tax years 2018 to 2026 but roughly doubled the child tax credit and the standard deduction. The latter reduced taxable income by $12,000 for individual filers and $24,000 for married couples filing jointly for tax year 2018. (The standard deduction for tax year 2017 was $6,500 for single filers and $13,000 for married couples).  

The Act specifically raises the exemption and phase out levels for the alternative minimum tax, which is typically levied on individuals earning income above a certain threshold.

Key Takeaways

  • Exempt income is any income that isn't subject to federal tax.
  • The types and thresholds for exempt income can be changed through the political process.
  • Income from some types of investments, like muni bonds, qualify as exempt income.
  • There are other types of income that are exempt from state level taxes. Some income may be exempt at the state level but still taxed at a federal level.

Types of Exempt Income 

There are several types of income and benefits that are nontaxable under certain circumstances. Several health-related benefits are tax exempt including benefits from employer-sponsored supplemental disability insurance purchased with after-tax dollars, private insurance plans funded with after-tax dollars, most benefits from employer-sponsored health insurance plans, and worker's compensation. 

Gifts that exceed a certain value can trigger a gift tax on the person providing the gift. However, any gift worth less than $15,000 (as of 2018) is exempt from income tax. Regardless of value, certain gifts including tuition and medical expenses paid for someone else and charitable donations are income tax exempt. The latter is also tax-deductible. 

Investments with Exempt Income

Distributions from health savings accounts (HSA) are only exempt from income tax if they are used for Qualified Medical Expenses. Qualified distributions from Roth 401(k) plans and Roth IRAs funded with after-tax dollars are tax exempt.   Other investments may also be protected from income tax. Interest gained from municipal bonds is exempt from federal income tax, and state income tax if you reside in the state where the bond was issued. Capital losses from sold investments can also reduce your taxable income by up to $3,000 per year.

The estate tax, often referred to as the death tax, applies to a certain portion of an estate only after it exceeds a certain threshold. The Tax Cuts and Jobs Act raises that threshold to $11.2 million for single filers and $22.4 million for married couples filing jointly for tax years 2018 to 2026— assuming no major Congressional action. The estate tax exemption for tax year 2017 was $5.49 million, so it was doubled for 2018.