What Is Exempt Income?

How Exempt Income Works

Your income is generally taxable unless a specific law exists to exempt it, according to the IRS. You must include and report income on your tax return, sometimes even if it's exempt. The nature of the income doesn't matter. It can be in the form of services performed for you or property transferred to you. It doesn't have to be cash.

If you were a single taxpayer in tax year 2022, $12,950 of your gross income, or total income, is exempt from federal taxes because this is the standard deduction available. For single taxpayers in tax year 2023, the standard deduction is $13,850.

All you have to do is claim the standard deduction on your return. You can subtract this number—and other sources of exempt income—from your total income, so you'll only pay taxes on the rest of your income.

Example of Exempt Income

Tax deductions and adjustments to income are used together to arrive at the total amount of your exempt income.

Using the example of the standard deduction, you would pay tax on only $47,050 if your overall gross income was $60,000 in 2022—that is, $60,000 less the $12,950 standard deduction. This assumes that you're not eligible to claim any adjustments to income, as well. You must choose between itemizing or claiming the standard deduction. You can't do both.

You can also claim adjustments to income. Adjustments to income appear on Line 10 of the 2021 Form 1040, and your standard or itemized deductions are subtracted two lines later. Adjustments can include student loan interests or self-employment costs.

Types of Exempt Income

The list of adjustments to income and deductions provided under the Internal Revenue Code (IRC) is lengthy, but it shortens considerably if you claim the standard deduction in lieu of itemizing your deductions. Adjustments to income include money you spent on:

• Retirement plan contributions
• Educator expenses, if you're a teacher
• Health savings account (HSA) contributions
• A portion of your self-employment tax, if you're self-employed
• Self-employed health insurance costs
• Student loan interest

Itemized deductions include:

• State and local taxes paid, including property taxes
• Home mortgage interest and points paid
• Medical and dental expenses not paid by insurance
• Gifts to charity
• Casualty and theft losses due to a federally declared disaster

These lists of deductions and adjustments to income are not all-inclusive, and each comes with its own set of rules and limitations. You may also receive other exempt income, like dependent care benefits or tuition reimbursement from your employer.

Some types of exempt income are provided for by statutes other than those that establish deductions or adjustments to income. For example, gifts aren't taxable to the recipient as income, although the donor would generally be responsible for paying a gift tax rather than an income tax on a gift's fair market value.

Then there's alimony. You once had to include this as income if you received it, but this changed in 2018. It's now exempt if it's provided for in a divorce or separation agreement entered into in 2019 or later. The paying spouse is responsible for paying income tax on that money, although it may be deductible. Child support is also not taxable to the parent receiving it.

States Have Their Own Rules

Some states have their own laws for exempt income. For example, New Jersey exempts unemployment compensation, workers' compensation, and Social Security benefits. But up to 85% of your Social Security benefits might be subject to federal income tax, depending on your income.

Types of Taxable Income

As generous as the IRS might appear to be about exempting certain income, it does not exempt money from certain sources that you might think aren't taxable. This might include fringe benefits provided by your employer. It also includes royalties, some disability pension income, and income derived from bartering.

Here's how the last instance might work. Maybe your neighbor is an electronics whiz. You're a plumber. You unclog their kitchen sink, and they repair your ailing hard drive in exchange. You'll need to include the fair market value of the services you received as income on Schedule C (Form 1040).

How To Report Exempt Income

You still need to put exempt income down when you file your tax return. In most cases, the IRS wants to know what income you're exempting, how much, and why.

This will likely involve filing one or more additional forms with your Form 1040 tax return. For example, you would have to file Form 8839 if you want to exempt adoption assistance paid by your employer. Excluding dependent care benefits will require filing Form 2441. Adjustments to income must be reported on Schedule 1, and itemized deductions are reported and totaled on Schedule A.

The rules for exempt income are complex, and they may not always seem to make sense. Never assume that you don't have to pay taxes on certain sources of money. Report all income to the IRS, even if it's exempt. If you have questions, you should contact the IRS or consult with a qualified tax professional who can confirm what income is exempt and let you know what forms you need to file.

Frequently Asked Questions (FAQs)