Common Non-Taxable Income Types You Should Know

Common Non-Taxable Income Types You Should Know

It didn’t take long after becoming a dentist to understand just how much the “tax man” taketh from us.

Most people spend their entire career focused on earning an income from “taxable” sources.

But did you know that there are several non-taxable income types?

That’s right, and in this article we’ll highlight everything you need to know so you can begin focusing on which are best for you.

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What is Nontaxable Income?

Good news! Not all income is subject to tax. Nontaxable income, or tax-free income, refers to the revenue streams that the Internal Revenue Service (IRS) does not tax.

Nontaxable income sources generally do not need to be included in your taxable income. However, some nontaxable earnings still need to be reported on the tax return for informational purposes.

For detailed guidance, taxpayers can refer to the IRS’s Publication 525, “Taxable and Nontaxable Income.” This publication offers an in-depth explanation of various kinds of income. 

Here’s something else to consider, especially as you get closer to retirement age. There are states that don’t charge a state income tax including:

  • Alaska
  • Florida
  • Nevada
  • New Hampshire
  • South Dakota
  • Tennessee
  • Texas
  • Washington
  • Wyoming

Types of Non-taxable Income

Gifts and Inheritances

Gifts and inheritances are commonly excluded from an individual’s gross income for tax purposes. For instance, financial gifts below the annual gift tax exclusion limit, which was $17,000 for 2023, do not contribute to tax liability.

Similarly, most inheritances are not taxable, although estate taxes may apply to the estate’s value before distribution.

Life Insurance Payouts

Life insurance proceeds paid out upon an individual’s death are typically free from federal taxes. However, any interest received in addition to the insurance payout is taxable.

Disability Insurance Payments

Typically, disability benefits are not taxed if you’ve paid for the policy with after-tax dollars. Such benefits aren’t intended to replace your primary income fully. (This is why I started focusing on passive income from other sources, such as real estate, as I knew that disability insurance alone wouldn’t be enough.)

Related article: How Real Estate Syndication Works: An Investor’s Guide

However, if your employer covers all or part of the insurance premium, disability insurance payments become taxable. This is also the case for policies paid for with pre-tax dollars.

Additionally, workers’ compensation, compensation for non-punitive damages, benefits from public welfare funds, and payments under a no-fault car insurance policy for lost income or earning capacity due to injuries are also included in this tax-exempt category.

Government Benefits

Certain government benefits, such as welfare benefits, supplemental security income, and Social Security benefits, may be non-taxable or only partially taxed.

Unemployment compensation and workers’ compensation are also usually excluded from taxable income.

Educational Assistance

Employer-provided educational assistance can be excluded up to a certain limit of up to $5,250 for the tax year 2023.

Scholarships, grants, and tuition exemptions that are used for eligible educational expenses do not count as taxable income.

Health and Welfare Benefits

Payments from a health savings account (HSA) used for qualified medical expenses are not taxed.

Health insurance premiums paid by employers, including coverage provided under a group term life insurance policy, are excluded from an employee’s gross income.

Compensation for Injuries or Sickness

Compensation for physical injury or sickness, including both the injury itself and its associated medical expenses, is non-taxable.

However, this exclusion does not apply to emotional distress or punitive damages unless they originate from a physical injury or sickness.

Certain Business Concessions

Small businesses may receive certain non-taxable income, like cash rebates or profit-sharing payments. Additionally, interest from municipal bonds is often exempt from federal taxes, providing a tax advantage for those who invest in these securities.

Investment-Related Nontaxable Income

Municipal Bonds

 Investors typically look to municipal bonds for a secure source of nontaxable income. Interest earned on these bonds is generally exempt from federal income tax and, in some cases, state and local taxes if the holder lives in the state where the bond is issued.

Capital Gains 

Capital gains are a key component in the sale of investments. If an individual holds an asset for more than a year before selling, the gains are considered long-term and are taxed at a lower rate than ordinary income.

Some capital gains may be entirely nontaxable in certain scenarios, like the sale of a primary residence that meets specific conditions.

  • Short-term Capital Gains: Taxed as ordinary income.
  • Long-term Capital Gains: Taxed at a reduced rate.

Investment Income

Investment income (passive income) comes from various sources, but not all are subject to tax. For example, some life insurance contracts may generate investment income that beneficiaries receive tax-free.

Interest Income

 Generally, most interest income is taxable. However, there are exceptions, such as interest generated from municipal bonds, which may be nontaxable at the federal or state level.

S Corporations

Shareholders of S corporations benefit because their income, losses, deductions, and credits flow through to their personal tax returns, avoiding double taxation.

The income is only taxed at the shareholder level, making it a desirable option for business investment structures.

Entity Nontaxable Conditions
Municipal Bonds Interest exempt from federal, sometimes state and local taxes
Capital Gains Long-term gains taxed at lower rates; some exclusions may apply
Investment Income Certain life insurance benefits are nontaxable
Interest Income Some types exempt, such as from municipal bonds
S Corporation Income passes through to shareholders, avoiding double taxation
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Tax Benefits and Exclusions

The Internal Revenue Code offers various provisions that allow individuals to exclude certain types of income from their taxable income. These are designed to provide tax relief for specific situations, such as educational expenses and retirement savings.

Education-Related Exclusions

The IRS permits exclusions for certain education-related expenses. Qualified scholarships used for tuition and required enrollment fees are not taxable. Additionally, the student loan interest deduction allows a deduction of up to $2,500 of interest paid on student loans. Employers can also provide up to $5,250 of tax-free educational assistance.

Retirement Contributions and Distributions

Contributions to traditional IRAs are made with pre-tax dollars, which may be deductible to the extent that they do not exceed the limits set by the IRS.

Conversely, Roth IRAs are funded with after-tax dollars, with the benefit that qualified distributions are tax-free. For retirement plans like 401(k) and 403(b) plans, growth in the account is not taxed until distribution.

Also, catch-up contributions are allowed for individuals 50 or older, enabling them to set aside additional funds for retirement tax-deferred.

Employer Benefits

Various employer-provided benefits are excluded from taxable income. For instance, contributions by employers to employee stock ownership plans (ESOPs) and pension plans do not count as taxable income when made.

Fringe benefits, such as qualifying group term life insurance up to certain limits and health insurance premiums paid by the employer, are generally non-taxable to the employee. Contributions to health savings accounts may be made pre-tax or are tax-deductible, and the growth within these accounts is tax-free when used for qualifying medical expenses.

Account Growth

Investment accounts like those for education, known as 529 plans and HSAs, offer tax-free growth as long as withdrawals are used for their intended purposes.

For 529 plans, this would include tuition, books, and other qualified educational expenses, while for HSAs, it encompassed medical expenditures. These accounts encourage savings by allowing the funds within them to appreciate without being diminished by taxes each year.

Frequently Asked Questions

What types of income are not subject to federal taxation?

Certain types of income are exempt from federal taxes, including gifts and inheritances, life insurance payouts, and qualified educational assistance from an employer.

How can one identify non-taxable income on a W-2 form?

Non-taxable income does not generally appear on a W-2 form, as this document reflects earnings subject to income taxes. Some exceptions, like employer-provided healthcare, may be noted separately.

What are the criteria for income to be classified as non-taxable by the IRS?

Income must meet specific criteria outlined by the IRS, such as falling under a certain threshold or being used for qualifying purposes, like educational expenses or healthcare premiums.

Are there specific types of employer-provided benefits that are exempt from taxes?

Yes, certain employer-provided benefits like health insurance, qualified educational assistance, and adoption assistance are tax-exempt up to specific limits.

In what scenarios does income from sources other than employment not require tax payment?

Income from sources like financial gifts, life insurance benefits, and certain scholarships do not usually require tax payment.

What distinguishes untaxed income from tax-deferred income?

Untaxed income is never subject to federal taxes. Tax-deferred income is taxed at a future date, such as withdrawals from retirement accounts like 401(k)s or IRAs.