Exempt income refers to certain types of income not subject to income tax. Some types of income are exempt from federal or state income tax, or both. IRS guidelines determine which types of income are exempt from federal income tax and the specific circumstances for each exemption. States have their unique set of rules defining what qualifies as exempt income.
Key Insights to Empower Your Tax Strategy
- Exempt income is not subject to taxation.
- Some income may be exempt at state level but taxable federally.
- Income from certain investments, like municipal bonds, qualifies as exempt income.
- Distributions from Roth 401(k)s and Roth IRAs are tax-exempt.
- Benefits from employer-sponsored disability insurance and most benefits from employer health insurance plans are exempt from taxes.
Breaking Down Exempt Income
Some types of income and benefits are nontaxable under particular situations. Various health-related benefits are tax-exempt, including those from employer-sponsored supplemental disability insurance purchased with after-tax dollars, and most benefits from employer-sponsored health insurance plans.
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Gifts exceeding certain values may trigger a gift tax on the person giving the gift. However, gifts worth less than $17,000 in 2023 and $18,000 in 2024 are exempt from income tax. Regardless of value, medical expenses paid for someone else and charitable donations are also income tax-exempt.
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The Tax Cuts and Jobs Act (TCJA) eliminated personal exemptions from tax years 2018 to 2026 but roughly doubled the standard deduction.
Standard Deductions
|
2023 Tax Year | 2024 Tax Year |
|---|---|---|
| Single Taxpayers & Married Couples Filing Separately | $13,850 | $14,600 |
| Married Couples Filing Jointly | $27,700 | $29,200 |
| Heads of Household | $20,800 | $21,900 |
Choose between taking the standard deduction or itemizing your deductions when filing taxes. Examples of itemized deductions include medical expenses, mortgage interest, and charitable donations.
Examples of Exempt Income
- Health Savings Accounts (HSAs): Distributions are only exempt if used for qualified medical expenses.
- Roth 401(k) and Roth IRAs: Qualified distributions funded with after-tax dollars are tax-exempt.
- Municipal Bonds: Interest earned is exempt if you reside where the bond was issued.
- Capital Losses: Reduced taxable income up to $3,000 annually.
- Life Insurance Benefits: Nontaxable income but may be subject to estate tax.
The Alternative Minimum Tax (AMT) exemptions are in effect until 2025.
Examples:
For tax year 2023, exemption amounts are $81,300 with a phase-out at $578,150 for individuals, and $126,500 for married couples filing jointly with a threshold at $1,156,300.
For tax year 2024, the exemption is $85,700 for singles, compounding to phase out at $609,350. For married couples, exemption is $133,300 with a phase-out beginning at $1,218,700.
What Types of Income Are Tax Exempt?
Income from municipal bonds and distributions from Roth 401(k)s and Roth IRAs, employer-sponsored supplemental disability insurance, and health insurance plan benefits constitute tax-exempt income.
Unemployment Income and Taxation
Unemployment benefits are federally treated as ordinary income. However, state taxation on unemployment income varies based on the program providing the benefits
Understanding Gift Tax
In 2023, gifts less than $17,000 aren’t subject to income tax. This value increases to $18,000 in 2024.
Conclusion: Optimize Your Tax Savings
Almost all income forms, including wages, salaries, tips, and income from employers or freelancing, are taxable. However, certain types of income aren’t taxable—like distributions from some retirement accounts, under-limit gifts, certain benefits, and private insurance plans come under exempt income category. Developing awareness about exempt income is key to effective tax planning and maximizing financial gains.
Related Terms: Income Tax, Standard Deduction, Itemized Deductions, Charitable Contributions, Capital Losses, Life Insurance Benefit, Alternative Minimum Tax.
References
- Internal Revenue Service. “Traditional and Roth IRAs”.
- Internal Revenue Service. “Employer-Provided Health Coverage Informational Reporting Requirements: Questions and Answers”.
- Internal Revenue Service. “Publication 525: Taxable and Nontaxable Income”.
- Internal Revenue Service. “IRS Provides Tax Inflation Adjustments for Tax Year 2024”.
- Internal Revenue Service. “Frequently Asked Questions on Gift Taxes”.
- Tax Policy Center. “How Did the TCJA Change the Standard Deduction and Itemized Deductions?”
- Internal Revenue Service. “IRS Provides Tax Inflation Adjustments for Tax Year 2023”.
- Internal Revenue Service. “Roth Comparison Chart”.
- Internal Revenue Service. “Roth IRAs”.
- Internal Revenue Service. “Publication 969, Health Savings Accounts and Other Tax-Favored Plans”.
- Internal Revenue Service. “Topic No. 409 Capital Gains and Losses”.
- Internal Revenue Service. “Publication 550: Investment Income and Expenses”.
- Internal Revenue Service. “Estate Tax”.
- Internal Revenue Service. “Life Insurance & Disability Insurance Proceeds”.
- Tax Policy Center. “How Did the TCJA Change the AMT?”
- Internal Revenue Service. “Tax Exempt Bonds”.
- Internal Revenue Service. “Unemployment Compensation”.
