What Is Nontaxable Income?

Nontaxable Income Explained

Woman sitting at kitchen table calculating income on a computer

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Nontaxable income is income that is not subject to taxes. Although most forms of income from wages are taxable, there are income types that are tax-free, such as life insurance benefits and child support.

Definition and Examples of Nontaxable Income

Certain types of income are considered nontaxable according to the IRS. Typically, nontaxable income does not include the earnings from your job. Instead, it's comprised of other sources not related to wages and certain investment gains.

For example, 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.

An exception to this rule exists if you're self-employed and use the accrual method of accounting. You would claim income at the time you earn it in this case, regardless of whether you've actually received it yet.

How Nontaxable Income Works

Nontaxable income is money you received that's considered tax-free, meaning it's not subject to taxes. Typically, the income you have earned is taxable via federal and state taxes. However, there are certain types of income that might be taxed differently at the federal versus the state level.

As a result, it's important to check your local state tax code since state tax laws can vary. 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.

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.

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 December 31, 2018
  • Inheritances (although inheritances of more than $12.06 million may be taxable to the estate as of tax year 2022)
  • Gifts (although gifts totaling more than $16,000 might be taxable to the giver as of tax year 2022
  • Lawsuit proceeds representing payment for pain and suffering
  • Cash rebates on purchased items
  • Most healthcare benefits
  • Qualifying adoption reimbursements
  • Municipal bond interest

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:

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 Can Fit Both Categories

Not all income sources are clearly taxable or non-taxable. 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.

It's best to consult a tax professional if you have questions about whether your income is nontaxable or taxable since the rules can be complicated.

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. You can contribute up to $6,000 to a traditional individual retirement account (IRA) if you're under age 50 and up to $7,000 if you're age 50 or older for the tax year 2022. In 2022, you can contribute up to $20,500 for 401(k)s and $27,000 if you're age 50 or older.

With traditinal 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 is usually if you've owned the assets for at least one year and one day.

Key Takeaways

  • Nontaxable income is income that is not subject to taxes.
  • Most forms of income from wages are taxable, but some income types are usually tax-free, such as life insurance benefits and inheritances.
  • Other types of nontaxable income might include public assistance or welfare grants, alimony and child support, death benefits, and gifts.
  • In some cases, scholarships, certain retirement plans, and Social Security income may avoid taxation, but there are many exceptions.
  • Strategies exist that can reduce your tax liability, particularly in areas of retirement distributions and capital gains.

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