Table of Contents
Table of Contents

Exempt Income: Definition, Examples, and Tax Rules

What Is Exempt Income?

Exempt income refers to certain types of income that are not subject to income tax. Some types of income are exempt from federal or state income tax, or both. The IRS determines which types of income are exempt from federal income tax and the circumstances for each exemption. States have their own rules that define what counts as exempt income.

Key Takeaways

  • Exempt income is not subject to taxation.
  • Some income may be exempt at the state level but taxed at the federal level.
  • Income from some types of investments, like municipal bonds, qualifies as exempt income.
  • Distributions from Roth 401(k)s and Roth IRAs are also tax-exempt.
  • Income from benefits, such as employer-sponsored supplemental disability insurance and most benefits from employer-sponsored health insurance plans, are exempt from taxes.

Understanding 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 $17,000 for 2023 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. Charitable contributions are also tax-deductible. 

Exempt income rules underwent changes under the Tax Cuts and Jobs Act (TCJA) signed into law in December 2017. For example, the TCJA eliminated personal exemptions from tax years 2018 to 2026 but roughly doubled the standard deduction. For the 2023 tax year, the standard deduction is:

  • $13,850 for single taxpayers and married couples filing separately
  • $27,700 for married couples filing jointly
  • $20,800 for heads of households

When you file your taxes, you can choose between taking the standard deduction or itemizing your deductions. Examples of itemized deductions include medical expenses, mortgage interest, and charitable donations. Itemizing typically makes sense for higher-income earners who have large expenses to deduct.

Examples of Exempt Income

Distributions from health savings accounts (HSAs) 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. For example, interest earned 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.

If someone dies and you are the beneficiary of a life insurance benefit, that is also nontaxable income although it may make you subject to estate tax. 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, which is $12.92 million in 2023.

The exemption and phase-out levels for the alternative minimum tax (AMT), which is typically levied on individuals earning income above a certain threshold, are in effect until 2025. The tax exemption is $81,300 for 2023 and phases out at $578,150 in 2023. The exemption amount is $126,500 for married couples filing jointly and phases out at $1.15 million.

What Types of Income Are Tax Exempt?

Income from municipal bonds and distributions from Roth 401(k)s and Roth IRAs are tax-exempt. In 2023, gifts worth less than $17,000 are not subject to income tax. Income from employer-sponsored benefits—including supplemental disability insurance and most benefits from employer-sponsored health insurance plans—are also exempt.

Is Unemployment Income Taxed?

Unemployment benefits are treated as ordinary income by the federal government, but not all states tax unemployment income.

How Much Is the Gift Tax?

The gift tax ranges between 18% and 40% and is based on the size of the taxable gift. In 2023 the gift tax exclusion is $17,000. This amount is per donee. As such, you can give up to that amount per person during the tax year. So if you have four grandchildren, you can give them $17,000 in 2023 without incurring the annual gift tax.

The Bottom Line

Almost all forms of income are taxable. This means if you earn wages, salaries, tips, and other types of income from an employer or as a freelancer, you're liable for income taxes. But there are certain forms of income tax that aren't taxable. Exempt income includes things like distributions from some retirement accounts, gifts under a certain amount, certain benefits, and private insurance plans. If you're unsure about your tax liability and whether you're on the hook, talk to a tax or financial professional to avoid any fines and penalties later on down the road.

Article Sources
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