Not every dollar you receive is considered taxable income by the IRS. Understanding the difference between taxable and nontaxable income is crucial for effective financial planning and can save you a significant amount of money during tax season.
The taxability of your income depends on specific IRS rules and regulations. To help you identify what you don’t need to report, we’ve compiled a guide to common categories of income that are generally not subject to federal tax.
1. Life Insurance Proceeds
When a beneficiary receives a payout from a life insurance policy after the insured person’s death, these funds are typically received tax-free. However, it’s important to note a few exceptions:
- Interest Earned: If the proceeds are paid in installments, any interest earned on the principal amount may be taxable.
- Cash Surrender: If a policy is surrendered for its cash value, any amount received that exceeds the total premiums you paid is generally taxable.
2. Disability and Workers’ Compensation Benefits
If you receive payments due to a disability, the tax implications depend on the source.
- Workers’ Compensation: Benefits received for an occupational sickness or injury are fully exempt from taxes if they are paid under a workers’ compensation act.
- VA Disability Benefits: Compensation and pensions received from the Department of Veterans Affairs are tax-free.
- Supplemental Security Income (SSI): SSI payments are also not considered taxable income.
3. Child Support and Alimony (Post-2018 Agreements)
Family-related payments have specific tax rules:
- Child Support: Payments received for child support are not considered taxable income for the recipient.
- Alimony: For any divorce or separation agreement executed on or after January 1, 2019, alimony payments are not taxable to the recipient, and they are not deductible for the payer. This is a reversal of the previous rule.
4. Gifts and Inheritances
In most cases, cash or property you receive as a gift or inheritance is not included in your taxable income. However, if the inherited property later generates income (such as dividends from inherited stock), that subsequent income is taxable.
5. Qualified Roth IRA Distributions
Withdrawals from a Roth IRA in retirement can be completely tax-free. To be considered a “qualified distribution,” the following conditions must be met:
- The account must have been open for at least five years.
- The account holder must be at least age 59½.
6. Federal Tax-Exempt Municipal Bond Interest
Interest earned from bonds issued by state and local governments (municipal bonds) is generally exempt from federal income tax. This can make them an attractive investment for those in higher tax brackets. Be aware, however, that some municipal bond interest may still be subject to state or local taxes.
7. Capital Gains on the Sale of Your Home
The tax code provides a significant benefit for homeowners. If you sell your primary residence, you can exclude up to $250,000 in profit from capital gains tax ($500,000 for a married couple filing jointly). To qualify, you must have owned and used the home as your main residence for at least two of the five years before the sale.
8. Long-Term Care Insurance Payments
Payments received from a long-term care insurance policy are typically not taxable. Similarly, reimbursements for medical expenses you receive from a health insurance policy are also considered nontaxable.
