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.

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

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 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.