When you receive any type of income, it's generally a safe assumption that you'll need to pay taxes on it. With this kind of mindset, you can avoid a lot of hassles (along with penalties and fees related to underpayment of taxes) down the road. At the same time, it's important to understand that there are some exceptions—and not every type of income is taxed by the Internal Revenue Service (IRS).
With a better idea of the common types of income that are not taxed at the federal level and the requirements/rules that are in place, you may be in a better position to keep more of your hard-earned money come tax season.
Understanding Nontaxable Income
When income is nontaxable, this simply means that it is not subject to federal income tax. However, this doesn't mean you can get away with not reporting it on your return altogether. In general, all income should be reported on your tax return regardless of whether you will need to pay taxes on it or not.
Examples of Nontaxable Income at the Federal Level
While this is not a comprehensive list, some of the most common examples of nontaxable income include:
- Gifts and inheritances - This includes not just money, but other valuable gifts (such as property) that you receive. Although you may not pay an income tax on these, keep in mind that you may be subject to separate estate or gift taxes.
- Roth IRA withdrawals - Because you contribute to a Roth IRA account with after-tax dollars, you don't need to pay income tax again when you eventually withdraw money from this type of retirement account.
- Life insurance proceeds - When you receive a life insurance death benefit, these are typically not considered income and are thus not taxed federally. However, in some cases, interest earned on the proceeds of a life insurance benefit may be taxed separately, so this is something to keep in mind if you are a beneficiary listed on one of these policies.
- Health and disability benefits - Withdrawals from Health Savings Accounts (HSA) are typically not taxed as income, provided that the money is used for qualified medical expenses only. The same generally applies to workers' compensation benefits and some disability benefits.
- Municipal bond interest - These are usually exempt from federal income tax and, in some cases, might even be exempt from state and local taxes—making them a popular option among investors.
Important Note: Rules and Requirements Must Be Met
Being able to forgo federal income tax on things like municipal bond interest and life insurance benefits is a welcome benefit at tax time, but it's important to understand that there are often strings attached to these different forms of nontaxable income.
Keep in mind that even if income is considered nontaxable at the federal level, this doesn't automatically mean that you won't have to pay state and/or local taxes on it. States can vary greatly in their tax requirements, so it's a good idea to familiarize yourself with the tax code where you live and file your tax return.
Likewise, many of these types of nontaxable income require certain rules or stipulations to be met. Roth IRA distributions, for example, are only exempt from federal taxes if the withdrawal is taken after the age of 59.5 (or if another qualifying event occurs, such as a disability). If you take distributions sooner, you could be on-the-hook for income tax and other fees.
What About Recent Changes to Tax Law?
Tax laws change and evolve—so income that's considered nontaxable one year could be taxed the next. Consider, for example, how recent legislation added temporary deductions for overtime earnings and tip income. While these new deductions may reduce your total tax owed, deductions are not the same as nontaxable income. Regardless, taxpayers are responsible for staying on top of the latest laws and legislation to ensure they are filing their returns and paying their taxes as accurately as possible.
Don't Leave Your Hard-Earned Money on the Table
By recognizing these common examples of nontaxable income at the federal level, you might be able to keep more of your hard-earned money in your pocket once tax season rolls around. Just be sure that you meet any and all eligibility requirements for income to be considered nontaxable—and consult with a tax professional if you have any questions or uncertainty about your unique tax situation. From there, you'll be able to file with confidence and avoid paying unnecessary taxes.
If you have questions or would like additional information, please contact our Tax Services department.