Which Types of Compensation Are Exempt From Taxes?
According to the IRS, all forms of income can be taxed unless they are specifically exempted by law. What this means is that almost any money you make during the year is taxable by the federal government. Virtually all earned income, which includes wages, self-employment, capital gains, and dividends, is taxable. Lots of other, less common forms of income can also be taxed, including alimony, unemployment insurance, gambling wins, employer gifts, and forgiven debts.
So what are these forms of compensation that are specifically exempted? Here are a few important exceptions to taxable income that all filers should know about.
In most cases, individuals whose only form of income is through Social Security will not have to pay taxes on those benefits. However, those who earn money from outside sources while collecting social security will have to pay taxes if their combined income is more than their “base amount.” This amount is determined by one’s filing status.
For those filing as an individual:
- You’ll pay tax on up to 50 percent of your benefits if your combined income is between $25,000 and $34,000.
- You’ll pay tax on up to 85 percent of your benefits if your combined income is above $34,000.
For those filing a joint return:
- You’ll pay tax on up to 50 percent of your benefits if you and your spouse’s combined income is between $32,000 and $44,000.
- You’ll pay tax on up to 85 percent of your benefits if you and your spouse’s combined income is above $44,000.
Couples who are married but file a separate return will likely have to pay taxes on their benefits. No matter how much extra income you earn, you won’t be taxed on more than 85 percent of your benefits.
Life insurance is designed to pay recipients only if the policyholder passes away. To help encourage these types of helpful benefits, the government will generally not tax recipients on this income. Insurance payments can be taxed if one surrenders a policy for cash. In this case, any proceeds greater than the original cost of the policy will be taxed.
Much like life insurance, income from some disability policies is not subject to tax. A major exception to this is employer-funded disability benefits. The following types of disability are NOT taxable:
- Workers’ compensation benefits
- Supplemental disability plans purchased through an employer with after-tax dollars
- Private disability insurance purchased with after-tax money
- Disability payments from a public welfare fund
Cash and Other Gifts
The IRS technically considers gifts to be taxable income. However, any taxes owed are to be payed by the giver, not the receiver. So if you get a sizable cash gift or "early inheritance," you generally won’t have to worry about paying any taxes on it. The giver only has to pay taxes if the gift is more than $15,000. For married couples, the limit is $30,000. In rare cases, the IRS may come after the receiver if the donor refuses to pay the gift tax.
Filers should note that gifts from employers and prize earnings are not included in this exemption. Both of these are considered taxable income.
As of 2020, the tax threshold on estate inheritances is $11.58 million per person. This is more than double the $5.45 million in 2016. This means that if you receive money or assets from a will, you won’t have to pay taxes on any of the income under that threshold. Assets above that limit are subject to tax (with 37 percent being the top federal estate tax rate). As with gifts, the tax burden technically falls on the giver (the estate). It should be noted that since the giver will be dead, the estate tax will directly affect the amount received by the heir. Inheritors should also remember that non-cash assets like property can also be taxed.
Scholarships and Grants
Thankfully for many students, monetary benefits from scholarships and fellowships are not taxed. The government finds it better to encourage enrollment rather than to effectively add to tuition and other school costs. However, scholarship money that goes toward room and board does not qualify for the exemption and can be taxed as income.
Tax on Government Bond Investing
Government bonds have been considered one of the safest investments available in the United States for years. Even after the debt crisis in 2008, government bonds still remained a relatively safe and stable investment tool. This stability combined with special tax advantages is perhaps the reason why many people use government bonds for regular investment purposes.
A government bond is a way for the government to raise money through investors. These inventors can include both United States citizens and foreigners. In the United States, the term "Government Bonds," includes:
- Savings Bonds (Series EE, Series I, and Series H)
- Treasury Bonds
- Treasury Inflation-Protected Securities (TIPS)
Government bonds in the United States are considered risk-free securities. This provides a benchmark for other securities when measuring risk.
Because the federal government wants to encourage the purchase of government bonds, there are certain federal and state tax advantages available.
Interest on any government bond is not taxable at the state level. This is mostly due to the fact that the state cannot tax the federal government, but it is also a tax advantage for investors as well. Some government agency bonds are also not taxable at the state level, including securities from Ginnie Mae (the Government National Mortgage Association).
Taxpayers that hold zero coupon government bonds must report a portion of the interest that they receive as income each year, even though the interest has not been paid out. Savings bonds, on the other hand, often have deferrable taxable interest. This means that you can pay tax on the interest as if it were a zero coupon bond, or you can wait to receive interest and pay tax on it when the bond has matured. Most investors choose to wait to pay interest.
Series EE and I bond interest may be excluded from income if you are paying higher education expenses with the interest.
Series H bonds pay interest semiannually, and this amount must be reported as income.
Interest Earned from Municipal Bonds
Municipal bonds are bonds issued by local governments, including cities, counties, and states. These bonds serve the same purpose as federal government bonds, but they offer additional tax advantages as well.
Interest on municipal bonds is completely exempt from federal income tax. It may also be exempt from state and local taxes as well if the bond is supporting the location in which you live. These bonds are also very low-risk investments, and they can be a good way to preserve wealth. The interest rate is relatively low on this type of investment to reflect the low risk.
If you are looking for ways to invest your money while also gaining some tax advantages, government bonds or municipal bonds may be a good way to do that.
Many people believe that income received in cash or “under the table” does not need to be reported. This is not true. For example, all cash tips should be reported to one’s employer. Extra money earned doing side jobs like babysitting or yard work should be listed as self-employment income.
It’s important to remember that state tax requirements are different from federal tax laws. The most notable difference is for income tax. There are seven states that do not tax any form of individual income: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.
Q&A: How much of social security income is taxable?
If your only income source is social security you typically do not need to pay anything in taxes. If you received income in addition to social security, you may have to pay taxes on some of your social security benefits. To help determine this you need to look at the total amount of income including social security:
- For individual filers with incomes between $25,000 and $34,000, you will pay taxes on 50% of the social security benefits; If you file jointly with a partner, it's 50% for combined incomes between $32,000 and $44,000.
- For individual filers with incomes over $34,000 you may pay taxes on up to 85% of the benefits; For joint filers it's incomes over $44,000.