What Is Nontaxable Income?

How Nontaxable Income Works

When you earn money from a job or investment, you likely have to pay taxes to the government on it. However, there are certain types of income that the IRS does not collect taxes on. Nontaxable income is money you received that's considered tax-free, meaning it's not subject to taxes. Typically, nontaxable income includes other sources not related to wages and certain investment gains.

Examples of Nontaxable Income

Some investments earn tax-free income, such as the interest on municipal bonds. Typically, withdrawals from your retirement account are taxable, except for Roth retirement accounts.

Public assistance programs that offer income to the financially needy are often nontaxable, such as needs-based public assistance from Supplemental Security Income. Also, public welfare funds, no-fault auto insurance disability insurance payments, or disability benefits for which your employer paid the insurance premiums are considered nontaxable.

It's important to check your local state tax code since state tax laws can vary, too. Many states tax wages while others do not. For example, New Hampshire doesn't have an income tax, but the state charges a 5% tax on interest and dividend income. However, New Hampshire residents are still required to pay federal income tax.

Types of Nontaxable Income

Some types of nontaxable income include:

• Worker's compensation payments
• Employer-provided health insurance
• Life insurance death benefits, but not proceeds when a policy is cashed in
• Child support
• Alimony received under decrees or court orders made after 2018
• Inheritances
• Financial gifts
• Lawsuit proceeds representing payment for pain and suffering
• Cash rebates on purchased items
• Most healthcare benefits
• Qualifying adoption reimbursements
• Some municipal bonds

Typically, you don't need to enter most of these nontaxable income sources on your tax return, but if you do, they are not usually taxed.

Nontaxable vs. Taxable Income

Taxable income includes most forms of earned income or anything received in exchange for money, services, or property.

Taxable income includes:

• Wages, salaries, tips, and self-employment income
• Employee bonuses, awards, and commissions
• Severance pay and unemployment compensation
• Rental income
• Stock options, dividends, interest, and capital gains

Taxable income is taxed in the year it was received, ending Dec. 31. Taxable income from your employer would likely appear on your W-2 statement. However, income might be reported differently for independent contractors and business partners.

On the other hand, nontaxable income is tax-free money. Nontaxable income is usually not earnings or wages from your job or place of employment. Common nontaxable income sources include worker's compensation payments, life insurance death benefits, inheritances, alimony, and child support.

Income That Is Both Taxable and Nontaxable

Not all income sources are clearly taxable or nontaxable. Some fall into a "maybe" category.

Scholarships typically aren't taxable, unless you use the money for something other than tuition, fees, or approved educational expenses. You'll generally pay taxes on any portion you use for room and board or for that new laptop that wasn't strictly required for any of your courses.

Some employee achievement awards escape the tax net. It depends on factors such as the type and value of the award. The same goes for non-qualified deferred compensation plans. If you contribute to certain retirement plans, that money isn't taxable in the tax year you do so, but the IRS will tax your distributions when you take the money out later. Roth plans are an exception to this rule because you receive no tax break at the time you make contributions.

A portion of your Social Security retirement income may or may not be taxable. It depends on how much other income you have earned.

How To Reduce Your Tax Liability

You can use some tactics to tweak your tax situation a little more to your benefit.

First, remember that many retirement plan contributions aren't taxable in the year you make them. For tax year 2022, you can contribute up to $6,000 to a traditional IRA if you're under age 50 and up to $7,000 if you're age 50 or older. For tax year 2023, you can contribute up to $6,500 and $,7500, respectively. For 401(k)s, the limit is higher. For tax year 2022, you can contribute up to $20,500, and for tax year 2023, you can contribute up to $22,500. If you're age 50 or older, you can contribute up to $27,000 to a 401(k) for tax year 2022, and up to $30,000 for tax year 2023.

With traditional IRAs and 401(k)s, you reduce your taxable income in the tax year of the contribution, but distributions or withdrawals are taxable. Some plans are also subject to required minimum distribution (RMD) laws, which require you to withdraw money, meaning you might pay taxes on more income than you need.

You must typically take your first RMD in the year you turn age 72. You don't have to wait until age 72, but you'll have to pay a 10% penalty if you do so before age 59 1/2, except in special circumstances.

You can minimize capital gains taxes in non-retirement investment accounts by making sure they qualify for long-term tax rates, which usually apply when you've owned the assets for more than one year.

Frequently Asked Questions (FAQs)