Non-taxable or tax-exempt income is money or property you receive from various sources for which you are not required to pay income tax.
Our Raleigh-based tax preparation professionals have put together this quick guide so that when tax season comes around you have a better understanding of what is and is not required to be reported on your IRS forms.
What’s the Difference Between Taxable and Non-Taxable Income?
The first step in understanding which income is exempt from tax is to differentiate between taxable and non-taxable income. Taxability of income is determined under the Internal Revenue Code. Generally, money earned through work or most investments is taxable and you normally receive an annual form W-2 or 1099 related to this income.
Examples of taxable income for which you are required to report yearly to the IRS are:
- Salary, wages, tips, and self-employment income
- Bonuses and commissions
- Unemployment pay and severance pay
- Income from rental properties
- Capital gains, stocks, dividends, and interest
- Virtual, crypto-currencies like bitcoin
What Is Non-Taxable Income?
Non-taxable income is money or property you’ve received from certain sources which are not subject to federal or state income tax under the Internal Revenue Code or state tax regulations. Non-taxable income is generally not required to be reported on your tax return.
Examples of types of non-taxable income are:
- Employer-provided health insurance
- Generally disability pay
- Life insurance death benefits
- Child support
- Alimony (for agreements entered into after December 31, 2018)
- Adoption assistance benefits
- Personal injury lawsuit settlements
- Scholarship and financial aid income
- Cash rebates
- Assistance from disaster relief
Despite this being an extensive list of non-taxable income types, there are some instances where non-taxable income might become taxable based on external factors. For instance, scholarship and financial aid income, while generally not taxable, does become taxable for any amount awarded to the recipient that exceeds costs dedicated to their education.
If you are unsure of the nuances of particular income types when it comes to filing it on your IRS forms, it’s best to seek advice from an experienced tax consultant for assistance.
Most Common Types of Non-Taxable Income
There are plenty of instances where income is considered tax-free. However, each specific income type often has its own set of rules. The legality of whether or not an item of income is non-taxable, or if it becomes taxable is based on specific circumstances.
Let’s explore some of the most common types of non-taxable income to help you understand the reasons and stipulations regarding its non-taxable status.
Taxes on gifts are often the responsibility of the giver, not the recipient. If a financial gift is given that does not relate in any way to compensation for services, it is generally not taxable income. However, any gift given by an employer to an employee may be taxable. This does not fall under the scope of tax-free income, as employers can give nonfinancial gifts of $25 or less before being required to pay taxes on the financial gift. Any amount higher than $25 given by an employer to an employee is no longer tax-free. Employees of a company can give financial gifts of any denomination to each other without paying taxes on them.
You should keep in mind, however, that business bonuses and profit-sharing payments are not categorized as “gifts”. Instead, these are considered compensation for services and taxable to the employee.
In order to maintain a positive working environment, your company may provide benefits to its employees that are not considered financial gifts per se. These are not taxed, as they are considered “fringe benefits.”
Examples of fringe benefits might include:
- Health insurance
- Retirement plans
- Workers’ compensation
- Family and medical leave
- Mileage reimbursement
- Childcare reimbursement (if certain requirements are met)
- Tuition assistance (subject to limits)
- Meal subsidization
To be eligible for disability compensation, an employee must have been deemed temporarily or permanently handicapped due to a physical injury or illness. Disability payments and workers’ compensation for people with disabilities are normally not subject to taxation. However, taxes will be levied on disability benefits if they are derived from an insurance policy that was paid by the employer.
Many disability benefits are not subject to federal income tax. Additional disability benefits paid by after-tax dollars, private disability insurance, and workers’ compensation are included in this category. Additionally, compensation for injury, illness, or loss of function that is not punitive is not taxed.
Health Insurance Provided by the Employer
Employee medical insurance premiums paid by the employer are not taxable since they are not included in the employee’s taxable income. However, any additional employee compensation in excess of medical premiums might be seen as a gift, which is taxed a little differently as explained above.
Insurance premiums paid for by a third party or via a health reimbursement agreement are both exempt from federal income tax.
Life Insurance Proceeds
Life insurance proceeds are non-taxable sources of income for the beneficiary. The deceased individual was the insured, and as the person receiving the proceeds of their policy it is not considered to be a part of your gross income, therefore you do not need to report these earnings on your tax return. However, if any interest was incurred on the policy, you must report the interest because interest is considered taxable income.
Whether it is in the form of cash, investments, or property income from inheritances is not taxed in the state of North Carolina. If the deceased lived in a state other than NC, you will have to check that state’s inheritance tax laws.
Estate taxes, which are comprised of a person’s assets at the time of their death, are collected on estates with a value greater than a specified limit. Individuals are free from paying estate taxes up to a maximum of $12.06 million (for 2022). If you exceed this tax exemption, you will have to report and possibly pay estate taxes.
Alimony and Child Support Payments
After a divorce, the individual who receives alimony or child support payments does not have to report these earnings as part of their gross, taxable income. As of 2019, the individual who pays the alimony can no longer file these expenses as tax deductible.
Scholarships, Grants, and Financial Aid Income
Scholarships, grants, and financial aid earnings are non-taxable income that you may receive throughout the year, though there are some fine print details that would result in some of these earnings being susceptible to taxation.
A scholarship is a monetary assistance generally given to students who excel in their studies. The money received from a scholarship does not need to be reported on a tax return.
Grants and financial aid payments are financial payments made by an organization or institution—usually governmental—given out for special purposes. Grants and financial aid are meant to be used for necessities associated with your education, such as tuition, books, or other needs related to your degree program.
The money received from grants and financial aid service is non-taxable income unless the amount received exceeds what was needed to cover the costs related to your education. Any income received from these programs that were not spent or allocated toward their intended purpose is considered taxable income.
Interest Paid on Government Issued Municipal Bonds
When you buy bonds, you’ll almost always have to pay taxes on the interest you earn. However, when it comes to government-issued municipal bonds, the interest is tax-free federally, and if you live in the state where the bonds were issued, your income is normally tax-free at the state, and municipal levels as well. Even if you choose to invest in municipal bonds indirectly through a mutual fund, you are eligible for this tax deduction.
Treasury bills, notes, and bonds yield interest that must be reported on a federal income tax return, but this interest is exempt from state and local taxes. The interest rate on municipal bonds is often lower than the interest rate on other kinds of bonds.
You can deduct up to $3,000 a year from your taxable income if you sell investments at a loss. In addition, capital losses can be carried over from year to year until they are fully offset. It’s possible to deduct $3,000 from your 2022 income on your tax return and an additional $1,500 from your 2023 income if you sold investments in 2022 for less than their original cost (i.e., a loss of $4,500).
Tax-free Wages for State Tax
Wages received in states without a state income tax are generally considered tax-free income, therefore they are not subject to state withholding taxes. However, the federal government still levies taxes on this income.
Alaska, Nevada, Florida, Texas, Tennessee, South Dakota, New Hampshire, Wyoming, and Washington are the only states where earnings are not taxed by the state.
How to Cut Down on Your Tax Bill
There are many strategies for handling tax deductions to reduce your tax bill. With the help of a professional in tax planning and preparation, you can maximize your deductions.
Many retirement plan contributions aren’t taxed in the year you make them. For the tax year 2022, you may be able to contribute up to $6,000 to a regular IRA if you’re under 50, or $7,000 if you’re 50 or over. In 2022, 401(k) contributions are capped at $20,500 for everyone under the age of 50 and $27,000 for everyone aged 50 or over.
With traditional IRAs and 401(k)s, you lower your taxable income in the tax year of the contribution, but distributions or withdrawals are taxable. This differs from a Roth IRA or 401(k) where contributions are not deducted from taxable income, however when the funds are withdrawn the principal and any income earned is tax-free.
Other retirement plans may be available if you are self-employed or a small business owner.
How Do I Know if I Owe Federal Tax?
If having a job is your sole source of income, chances are you won’t owe additional tax on it, as your tax withholdings should be set at a rate to cover the tax liability.
However, if you have additional income, are employed part-time or self-employed, receive a taxable pension, receive social security or have investment profits, you might have additional tax payments due.
Moreover, most home sales are tax-free if the profit is below a specific amount: $250,000 for a single seller and $500,000 for married couples filing a joint income tax return.
Contact a Tax Professional for the Best Suggestions
If you still don’t fully understand taxable versus non-taxable income, don’t worry– you are not alone! From confusing terminology and different laws surrounding taxing different types of federal or state taxes, it’s easy to become overwhelmed by the nuances and details associated with each particular type of income.
Consulting with a professional in tax preparation services will help you understand your financial obligations on a federal and state level. If you are looking for a Raleigh CPA with proven experience working with tax records call Steward Ingram & Cooper PLLC at (919) 872-0866 or fill out the form below.