What is Tax-Free & Non-Taxable 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.

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.

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.

There are a variety of illness and injury benefits that qualify as nontaxable income. The most common are as follows.

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 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.

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).

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.

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.

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.

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).

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.