What does the IRS tax? Just about everything. Here’s a quick guide to the difference between taxable and nontaxable income, plus a list of 13 types of tax-free income.
What income is nontaxable?
The Internal Revenue Code defines taxable income as gross income minus deductions. And gross income, federal law says, “means all income from whatever source derived.”
That’s a lot of territory, covering not only earned income such as wages but also unearned income from investments. If you operate on a cash-free basis, the value of items you receive as a barter exchange is taxable, too. So are gambling jackpots and prize winnings.
The IRS doesn’t care how you get your money, specifically saying, “Income from illegal activities, such as money from dealing illegal drugs, must be included in your income on Schedule 1 (Form 1040), line 21, or on Schedule C (Form 1040) … if from your self-employment activity.”
What income is tax-free income?
Here are 14 examples of tax-free income that Uncle Sam’s tax collector doesn’t get to reel in.
1. Educational assistance from your boss
You can exclude from your income up to $5,250 of qualified employer-provided educational assistance.
2. Adoption help from your employer
If your company helps you cover the cost of adopting a child, that’s usually not taxable income. For the 2019 tax year, the tax-free employer-provided adoption assistance was $14,080 per child. It increases to $14,300 per child in 2020. The amount you can exclude depends on your modified adjusted gross income.
3. Child support
Most divorced parents know that child support payments they receive are not taxable income.
4. Payments for caring for children
Government payments to foster parents for their care of children officially placed in their homes generally are tax-free income.
5. Workers’ compensation
If you get benefits for a workplace-related illness or injury under federal or a state’s compensation law, that money is tax-exempt. However, if part of your workers’ compensation reduces Social Security or railroad retirement benefits you’ve received, that part may be taxable. Also, if you go back to work on light duties, the salary payments might be taxable.
6. Life insurance proceeds
When these are paid to you because of the death of the insured person, the amount usually is not taxable. There are exceptions; IRS Publication 525 has the details.
7. Some canceled debts
If a lender cancels debt you owe, you may be able to exclude it from your gross income if the debt was canceled in a bankruptcy case, was canceled when you’re insolvent, was qualified farm debt, was debt associated with a qualified real property business, was intended as a gift or was for your home. There are exceptions and details to understand, so be sure to see IRS Publication 525.
8. Energy conservation subsidies
You upgraded your home’s air conditioning system and got a rebate from your electric service provider as a reward for your energy-saving efforts. That financial thank you, either as a direct or indirect subsidy for the purchase or installation of a home energy conservation measure, is generally tax-free income.
9. Municipal bond earnings
Interest you earn on state and local government obligations generally is not taxable. Even better, if you buy municipal bonds issued by the state in which you live, the interest usually isn’t taxable at the state level either. (Learn how to get started buying bonds.)
Financial gifts, either money or other assets, that you receive are not taxable. If any federal gift tax is owed on the present, it is the giver who owes the tax. (See more about how the gift tax works.)
There is no federal inheritance tax, so everything your great-uncle left you shouldn’t pose any immediate tax issues. However, if he left you an asset that produces income, such as a dividend-paying stock, then you may owe tax on the money the bequest earns. (See which states have inheritance taxes.)
12. Accelerated death benefits
If you receive death benefits from a life insurance contract or viatical settlement because you’re terminally ill or chronically ill, you may be able to exclude the money from your income.
13. Disaster relief payments
If you’re the victim of certain disasters, you typically can exclude money you get from the government or transportation carrier to pay for personal expenses, funerals, home repair and property replacements that insurance doesn’t cover.
14. Some withdrawals from a Roth IRA
You can withdraw your Roth IRA contributions — that’s the money you put in yourself, not the gains on that money — whenever you want, without owing any penalties or taxes, no matter how long your account has been open. That’s because the money you put in is money you already paid income tax on.
Maybe, maybe not
In some cases, a certain type of payment might be tax-free while another, very similar one will lead to a tax bill. Here are three instances where you need to take special care.
- Some legal settlements are nontaxable, but others are. To determine whether you owe the U.S. Treasury a piece of your court award, consider what the settlement replaces and why it was granted. Proceeds for emotional distress or mental anguish originating from a personal physical injury or physical sickness, for example, typically are tax-free. However, court-awarded punitive damages are taxable, even if the punitive damages were in connection with a settlement for personal physical injuries or sickness.
- Social Security generally is tax-free if it’s your only source of income. But if you have other income — for example, from a part-time job, a taxable pension or investment earnings — you could owe federal tax at your ordinary income tax rate on up to 85% of your federal government retirement benefits.
- Home-sale proceeds are tax-free for many, so long as the profit is at or below a certain threshold: $250,000 for a single seller and $500,000 for a married couple filing a joint return. But if you make a real estate killing, the IRS collects tax on the amount you pocket in excess of those thresholds.
Remember, too, that in some cases your personal circumstances, such as the amount of other money you make, could have an effect on apparently tax-free situations.
So when you find yourself receiving money you think is tax-free, double-check it. IRS Publication 525 has details on taxable and nontaxable income. A tax professional can help, and good tax software will walk you through all the variables as well.