What is Tax-Free & Non-Taxable Income?
As the name implies, tax-free income is not subject to taxation. This is clear, but there can be some confusion around what constitutes gross income, tax-free income and taxable income. Learn what nontaxable income means and when it may apply.
- Written By Thomas J. Brock, CFA®, CPA
Thomas J. Brock, CFA®, CPA
Thomas Brock, CFA®, CPA, is a financial professional with over 20 years of experience in investments, corporate finance and accounting. He currently oversees the investment operation for a $4 billion super-regional insurance carrier.Read More
- Edited ByLamia Chowdhury
Lamia Chowdhury is a financial editor at Annuity.org. Lamia carries an extensive skillset in the content marketing field, and her work as a copywriter spans industries as diverse as finance, health care, travel and restaurants.Read More
- Financially Reviewed ByPeggy James, CPA
Peggy James, CPA
Certified Public Accountant
Peggy James is a certified public accountant with a Master of Accounting. She has spent the past several years of her career focused on working in higher education finance roles. Peggy also has accounting and finance experience working in the corporate and nonprofit sectors.Read More
- Updated: March 20, 2023
- 7 min read time
- This page features 3 Cited Research Articles
- Edited By
- Gross income includes all income you receive, regardless of source and nature. Most of it is taxable, but federal laws allow for some exceptions.
- Tax-exempt income is income that is exempted from taxation per the Internal Revenue Code. Prominent examples of federally exempt income include interest income on municipal bonds and distributions from a Roth-style retirement account.
- Nontaxable income reflects tax-exempt income plus permissible income tax deductions, such as the contributions made to a traditional retirement account.
- Taxable income equals gross income minus nontaxable income. It is the figure used to determine your annual tax obligation.
Taxable Income vs. Nontaxable Income
To break down the distinction between taxable income and nontaxable income, let’s start with a concept that encompasses both — gross income. It includes all income you receive, regardless of source and nature. It includes things like salaries and wages, self-employed earnings, interest income, dividends, capital gains from asset disposals and gambling winnings.
Taxable income is the portion of gross income that is subject to taxation. It excludes income designated by the Internal Revenue Code as tax exempt, and it reflects permissible tax deductions. Ultimately, it is the figure used to determine your annual tax obligation within your personal finances.
According to the IRS, you can receive income in the form of money, property or services. All income is taxable unless it is specifically exempted by law. Moreover, income that is taxable must be reported on your annual tax return. Income that is nontaxable may have to be reported on your annual return.
How To Calculate Nontaxable Income
The process for calculating nontaxable income is straightforward. As implied above, it entails aggregating your tax-exempt income and permissible tax deductions. That said, depending on your situation, it can be difficult to pinpoint tax-exempt items and make sense of the myriad of deductions available to you.
12 Types of Nontaxable Income
Many tax filers rely on the assistance of a tax professional, but there are also ways to go about it on your own. Below, you will find an outline of 12 of the most common types of non-taxable income.
Generally, accident, health and long-term care insurance provided by an employer are not taxable. Employer contributions to qualified health spending accounts, such as flexible spending accounts (FSAs) and health spending accounts (HSAs), are also nontaxable.
Additionally, up to $50,000 of group term life insurance provided by an employer is exempt from taxes. In other words, if your employer pays a $300 annual premium for a life insurance policy with a $50,000 death benefit, you will not owe any tax on the $300. However, if your employer pays the cost of a policy with a death benefit greater than $50,000, you must pay tax on the cost of the coverage beyond $50,000.
For employer-provided disability insurance, things work a little differently. Disability benefits are taxable if your employer pays the premiums for the insurance coverage. However, the following disability benefits are nontaxable.
- Benefits received from supplemental disability insurance purchased through your employer with your after-tax dollars
- Benefits received from a private disability insurance policy purchased with your after-tax dollars
Illness and Injury Benefits
There are a variety of illness and injury benefits that qualify as nontaxable income. The most common are as follows.
- Qualified workers’ compensation payments
- Black lung benefits
- Health care reimbursements that were not previously deducted
- Disability benefits from a public welfare fund
- Medical and personal injury protection payments from certain auto insurance policies
Life Insurance Payouts
Generally, the death benefit payout from a life insurance policy is not taxable for the recipient. However, if you cash in or convert a life insurance policy you own, there could be tax ramifications.
That said, if you receive accelerated benefits from a life insurance policy to pay for health care associated with a terminal illness or chronic health condition, these payments usually aren’t taxable. Incidentally, these payments are often referred to as living benefits.
As a result of the Tax Cuts and Jobs Act of 2017 (TCJA), alimony payments relating to any divorce or separation agreement executed Jan.1, 2019 or after are not taxable for the recipient and are not tax-deductible for the payor.
Prior to the TCJA, alimony payments were tax-deductible for the payor and taxable for the recipient. This treatment is largely applied to divorce and separation agreements executed prior to Jan. 1, 2019.
Child Support Payments
Child support payments are not taxable for the recipient. The IRS classifies these payments as tax-exempt since they are considered a personal expense. Incidentally, child support payments are not tax deductible for the payor.
But non-custodial parents who pay child support may have an opportunity to take advantage of other deductions and credits, such as the Child and Dependent Care Tax Credit.
Disaster Relief Assistance
If you are the victim of a declared disaster and qualify for relief assistance, any money received is usually nontaxable income. In order to qualify, you must meet requirements established by the Federal Emergency Management Agency (FEMA).
Gain on the Sale of a Principal Residence
The IRS grants a tax exemption on the capital gain realized by the sale of principal residence. The exemption, known as the Section 121 exclusion, is available to anyone that meets the following criteria.
- You have lived in the property for at least two of the five years preceding the sale
- You have not utilized the exemption on another residence sale in the past two years
The exclusion only applies to gains totaling $250,000 for single filers and $500,000 for married filers. Excess gains are generally taxable.
The IRS considers a gift to be a transfer — either directly or indirectly — where the donor does not receive the monetary value of the gift in return.
According to the IRS, in the following cases, the party receiving them do not have to pay a gift tax.
- Gifts you recieve that are less than the annual exclusion for the calendar year ($16,000 per donee in 2022 and $17,000 per donee in 2023)
- Tuition or medical expenses paid on behalf of someone else
- Gifts provided to a spouse
- Gifts recieved by a political organization for its use (but they are not tax deductible for the donor)
For filers who opt to itemize their deductions, gifts made to qualifying charities are tax deductible to the extent of IRS limits.
At the federal level, inheritances are always tax exempt for recipients. However, the deceased’s estate may owe taxes depending on the amount of money bequeathed.
For 2022, the federal estate tax exemption is $12,060,000. For 2023, the exemption is $12,920,000. A bequeathed amount that exceeds the exemption is subject to tax.
Interest on Municipal Bonds
Generally, any interest income earned on bond investments is taxable. However, municipal bonds issued by states and other government bodies receive special treatment.
The interest earned on these instruments is generally tax exempt at the federal level. It can also be tax exempt at the state level if you live in the state where the bonds were issued.
Qualified distributions from HSAs are always tax-free at the federal level. However, you can only contribute to an HSA when enrolled in a high-deductible health insurance plan.
For 2022, the contribution limit is $3,650 for individuals ($7,300 for families). For 2023, the contribution limit is $3,850 for individuals ($7,750 for families).
Roth IRA Distributions
Qualified distributions from Roth-style individual retirement accounts (IRAs) are tax exempt. However, in the case of early withdrawals, earnings are subject to tax.
In some rare cases, early withdrawal penalties may also apply. Roth 401(k) plans and Roth 403(b) plans offer investors the same tax-exempt status as Roth IRAs.
Frequently Asked Questions
A non-qualified annuity is funded with after-tax dollars. It receives no up-front tax benefit. However, when you begin taking distributions, only the earnings on your investment are taxable. That said, if you purchase a non-qualified annuity using money from a Roth 401(k) plan or a Roth IRA, none of the distributions are taxable.
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3 Cited Research Articles
Annuity.org writers adhere to strict sourcing guidelines and use only credible sources of information, including authoritative financial publications, academic organizations, peer-reviewed journals, highly regarded nonprofit organizations, government reports, court records and interviews with qualified experts. You can read more about our commitment to accuracy, fairness and transparency in our editorial guidelines.
- Internal Revenue Service. (2022, October 27). Frequently Asked Questions on Gift Taxes. Retrieved from https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-gift-taxes
- Internal Revenue Service. (2022, November 10). What Is Taxable and Nontaxable Income? Retrieved from https://www.irs.gov/businesses/small-businesses-self-employed/what-is-taxable-and-nontaxable-income
- Tax Policy Center. (n.d.). Briefing Book: How Did the Tax Cuts and Jobs Act Change Personal Taxes? Retrieved from https://www.taxpolicycenter.org/briefing-book/how-did-tax-cuts-and-jobs-act-change-personal-taxes
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