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What Can and Can't Be Taxed?

Published in Taxable and Non-Taxable Income 5 mins read

Taxes apply to a wide array of income and assets, but many types of payments and benefits are specifically exempt from taxation by the IRS. Understanding the distinction between taxable and nontaxable income is crucial for individuals and businesses alike to comply with tax laws and plan their finances effectively.

What Can Be Taxed?

Generally, any income you receive that increases your wealth is considered taxable unless explicitly excluded by law. This includes most forms of earned income, investment gains, and certain benefits.

  • Wages, Salaries, and Tips: Your primary source of income from employment is almost always taxable. This includes your regular pay, bonuses, commissions, and tips.
  • Business Income: Profits derived from self-employment, independent contracting, or operating a business are subject to income tax and often self-employment taxes (which cover Social Security and Medicare contributions).
  • Investment Income:
    • Interest Income: Interest earned from savings accounts, bonds, and other investments is typically taxable.
    • Dividend Income: Payments from stocks you own, representing a share of company profits, are usually taxable.
    • Capital Gains: Profits from selling assets like stocks, real estate, or other investments for more than you paid for them are taxable.
  • Rental Income: Money received from renting out property is taxable income, though certain expenses related to the rental property can often be deducted.
  • Retirement Income: Distributions from pensions, 401(k)s, traditional IRAs, and other retirement accounts are generally taxable when you receive them in retirement, as these contributions were often made on a pre-tax basis.
  • Unemployment Compensation: Payments received from state unemployment funds are considered taxable income and must be reported on your tax return.
  • Gambling Winnings: Winnings from lotteries, casinos, horse races, and other forms of gambling are fully taxable.

What Cannot Be Taxed?

Certain types of income and financial benefits are generally deemed nontaxable by the IRS, meaning you do not have to pay federal income tax on them.

  • Inheritances: Money or property you receive as an inheritance from a deceased person is not subject to federal income tax. However, the estate itself may be subject to estate tax, and some states have their own inheritance taxes.
  • Gifts: Gifts received are generally not taxable income to the recipient. The person who gives a gift might be subject to gift tax if the value exceeds a certain annual exclusion amount, but this is usually paid by the giver, not the receiver.
  • Cash Rebates: Refunds or rebates you receive from a retailer for an item you purchased are typically considered a reduction in the purchase price, not taxable income.
  • Alimony Payments (for divorce decrees finalized after 2018): For divorce or separation agreements executed after December 31, 2018, alimony payments are no longer deductible by the payer or taxable to the recipient. This is a significant change from prior law.
  • Child Support Payments: Child support payments are neither taxable to the recipient nor deductible by the payer. This money is considered a transfer of funds for the child's support.
  • Most Healthcare Benefits: Generally, employer-provided health insurance premiums paid by an employer, and benefits received for medical care under an accident or health plan, are not taxable income to the employee.
  • Welfare Payments: Payments received from general welfare funds, such as Temporary Assistance for Needy Families (TANF), are typically not taxable.
  • Money Reimbursed from Qualifying Adoptions: Financial assistance received or reimbursed for qualifying adoption expenses is generally nontaxable. This often comes in the form of an adoption tax credit or exclusion.
  • Life Insurance Proceeds: Generally, proceeds from a life insurance policy paid to a beneficiary because of the insured's death are not included in gross income.
  • Municipal Bond Interest: Interest earned from bonds issued by state or local governments is typically exempt from federal income tax and often from state and local income taxes if you reside in the issuing state.
  • Workers' Compensation: Payments received for workers' compensation for an occupational sickness or injury are fully exempt from federal income tax.
  • Qualified Scholarships: Money received as a scholarship is tax-free if you are a degree candidate and use the funds for tuition and fees, as well as books, supplies, and equipment required for courses. Amounts used for room and board are taxable.

Summary Table: Taxable vs. Non-Taxable Income

Category Generally Taxable Generally Non-Taxable
Employment Wages, Salaries, Bonuses, Commissions, Tips, Unemployment Compensation Most Employer-Provided Health Benefits
Investments Interest, Dividends, Capital Gains Municipal Bond Interest (federal)
Family/Personal Alimony (pre-2019 divorce decrees), Gambling Winnings, Prizes Alimony (post-2018 divorce decrees), Child Support, Gifts, Inheritances, Cash Rebates, Adoption Reimbursements
Benefits/Other Retirement Account Distributions (e.g., 401(k), IRA), Severance Pay Welfare Payments, Workers' Compensation, Life Insurance Proceeds, Qualified Scholarships

It's important to note that tax laws can be complex and may vary based on specific circumstances and state regulations. For detailed guidance, it's always advisable to consult official IRS resources or a qualified tax professional. More information on taxable and nontaxable income can be found on the IRS website.