Most Common Examples of Non-Taxable Income
Most income is taxable by the I.R.S. according to its rules. Although there are specific instances when income is not taxable as ordinary income or capital gains. Most of the determinations lie contingent on various factors.
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When there is a court order for support, the party who is paying child support is typically the non-custodial parent, and the party who receives the support is the custodial parent. It does not matter how much child support the custodial parent pays, neither the payor nor the recipient can claim the child support on their tax return. For example, the payor cannot deduct the funds paid for a reduction in adjusted gross income, and the recipient does not have to report it on their tax return as income.
Combat pay is usually exempt for members of the U.S. military, and they need not pay taxes on funds or awards received while in service in a combat zone. Also, military members can count the combat pay towards the earned income tax credit. There are some exclusions to this rule. If, for example, you are in the service in a combat zone, you can count your income towards the earned income tax credit. However, some income may be counted for taxable income. This does not mean an individual would not owe tax. Depending on individual circumstances, it may cause a more significant income tax return. It is essential to consider outcomes in both ways to determine the better benefit.
Court awards may or may not be taxable depending on how the claim is based. The way court awarded damages are determined taxable is by the origin of the claim doctrine. If the awards are from damages for lost profits, then this is taxable income. Damages from a return of capital or injury are not ordinarily taxes as long as the funds do not exceed the basis of the property.
A lawsuit resulting in payment from lost wages is taxable income. I.R.S. Code (IRC) section 104(a) (2) is an exception to gross income for damages for physical injuries or physical sickness. The injuries must be noticeable by observation. This includes cuts, bruises, and swelling. Although emotional trauma can produce physical symptoms such as insomnia, anxiety, and headaches, for example, these awards on taxable. There are some exceptions to this rule. If the emotional trauma can relate to the physical injury, then this may be a substantial claim that the emotional trauma awards deemed nontaxable income.
For the emotional trauma claim to not be taxed as ordinary income, the settlement agreement must provide the basis of allocation. Otherwise, the individual taxpayer will not have met the burden of proof and cannot exclude the award from income taxes.
The I.R.S. does not tax gifts received except if they exceed $15,000 per recipient in one year. The person giving the gift is liable for reporting. However, there is a lifetime gift exemption of $11.4 million (as of 2019). If a person exceeds the gift tax, then the tax ranges between 18% to 40% of the monetary value of the gift depending on different factors.
For example, if your aunt gifts you and your brother each $15,000 totaling $30,000, she would be exempt from the gift tax because she has gifted you and your brother the annual maximum exclusion amount.
Health Savings Account (HSA)
To be qualified to have an HSA, an individual must meet specific requirements set by the I.R.S. An individual must have a high deductible health insurance plan in effect and not have any other health insurance. Exceptions are, workers’ compensation, long-term care, accident, dental, and vision are acceptable. There are no taxes on funds used on qualified medical expenses.
For example, if you have an HSA through your employer who contributes to your account $1,000 each year, you do not have to claim this as income. During the same year, you contribute $100 per month to the H.S.A. In September you incur a medical expense of $2,000 and have not had to use the money in the plan all year. So your HSA has 10 months’ worth of contributions of $1,000 to go with your employer’s contribution that totals $2,000. The H.S.A. would pay for your medical expenses. Your contributions are tax-deductible, and they do not tax the money withdrawn. The other benefits are any accounts that earned interest is not taxable, and the account is portable (if you change employers, the policy goes with you).
Home Sale aka Sale of Principal Residence
In most cases, homes increase in value over time, especially if the market conditions are positive. When a homeowner sells their home that increased in value over time, this generates long term capital gains from the sale of the primary home. Not all capital gains are taxable. The I.R.S. determines if capital gains are taxable by the home’s selling price minus the cost basis (what the owner originally paid for the house), any expenses from capital improvements, cost of selling the home. Next is filing status (married or single) and the home owner’s income tax bracket. There are three separate long-term capital gains brackets; 0%, 15%, and 20%.
The I.R.S. has exclusion amounts; If you are single, the exclusion amount is $250,000 and $500,000 for married couples filing jointly. For those who are single filing separate have $250,000 and must meet certain qualifications. For example, if you are single, and you purchased your home for $250,000, and 10 years later in the same year, you get married and sell your home for $600,000 with $200,000 in capital improvements. As long as you get married by December 31 of the year you sold the home, then you qualify for the $500,000 exclusion and must file jointly. $600,000 – $250,000 = $350,000 gain (this does not include cost of selling the home). Given the exclusion amount and filing status, you would not have to pay the capital gains tax.
If you were single, your situation would be different. Depending on your income will stipulate how much tax you would owe. For example, you had $350,000 in long-term capital gains, and you earn $80,000 each year. Your net income is $55,000 then the long-term capital gains tax bracket for a single filer is 15% (2019). So, your tax would be $350,000 x 15% = $52,500.
Most forms of inheritance are tax-free as defined by the federal government, however, depending on which state you live in, there may be a state inheritance tax. This is not the same as the estate tax. Once an estate has paid any taxes and distributes assets from the estate to the beneficiaries, that is the inheritance that is potentially taxed that the recipient pays. A notable exception is “income in respect of a decedent” (IRD). A retirement account is an example of an I.R.D. This is income that a recipient had the right to or earned during his or her lifetime. Common examples of I.R.D. are retirement accounts such as a 401(k) or I.R.A. If the person who owns a retirement account passes away and leaves it to a beneficiary, then the recipient would be responsible for paying taxes on the distributions in the form of income tax.
For example, a member of your family leaves you with his or her I.R.A. totaling $300,000 you would not pay any taxes on the amount until you take a distribution. You would pay tax on the principle (traditional I.R.A.’s are before tax funds) and the interest made on the portion of your distribution. If you take $30,000 in a year, and your adjusted gross income tax bracket is 25%, then you would owe $750. This amount is subject to change depending on what other taxes or deductions you have.
Insurance Through Your Employer
Most companies offer benefits to their full-time employees, such as insurance. This can be life and health insurance. Even though these funds used to purchase insurance by an employer for employees, the I.R.S. does not consider money used from an employer for insurance as employee income; therefore it is not taxable. If the company requires that the individual contributes to a part of the cost (which most do) there is a tax benefit that the employee can claim on their tax return for the insurance tax credit. However, there is no tax credit or deduction for life insurance premiums.
Life Insurance Payouts
Life insurance payouts are most often not taxed or required for the beneficiary to report it. There are various types of life insurance. In the basic forms, there are term and permanent insurance. Term policies are less expensive in terms of premium, and that is meant to expire at some point. Typically, 10, 20, 30-year terms, for example. They only pay the face value, and they do not carry any cash value with the death benefit.
Permanent insurance is variable, universal, and whole life. A whole life policy is the most expensive and have a set time to be paid in full. They build cash value on interest. The insurance company will determine the interest rate. Variable life insurance is tied to the stock market, as the cash in the account is invested. Universal life is like a hybrid between term and whole life. More expensive than a term and cheaper than a whole life, and the cash value is subject to interest rate fluctuations and over time.
If a recipient receives benefits from life insurance, the face value (the death benefit) is tax-free. However, some policies include the cash value aside from the death benefit. Meaning the cash value can go to the beneficiary in addition to the face value. So, for example, your grandfather bought a permanent whole life insurance policy for $100,000 fifty years ago. He paid up the policy in thirty years, and the cash value on the policy has grown on interest for 20 years. He passes away and leaves you the face value of $100,000 and the cash growth inside the policy of $25,000. You will receive the $100,000 tax-free, and the cash value will be subject to income tax on the interest earned from the $25,000. An actuary from the insurance company determines what part of the cash is the cost basis or principle and what is interest.
Roth IRA Interest
Owning a Roth is a tax-friendly retirement tool to have. All contributions are after-tax; so there are no tax deductions. However, any growth inside the account is tax-free as long as withdraws are a cost basis. The advantage of having the account is you can withdraw the cost basis (your original contributions) without penalty or income tax. Although, withdrawing interest and principle for an unqualified event before age 591/2 will result in income taxes on the interest withdrawn.
Scholarships and Grants
These are tax-free if used for educational expenses like tuition, equipment, and books. On the contrary, any amounts used to pay for room and board, are not qualified as educational expenses and are subject to income taxes. Some scholarships and grants will come with a coordination of benefits to keep recipients from double-dipping.
The I.R.S. has education credits to help with the cost of education. You can use tax credits to offset the additional expenses not covered in a scholarship or grant. A student may qualify for the Lifetime Learning Credit and/or the American Opportunity tax credits.
Workers’ Compensation and Disability Insurance
The compensation received for injury on the job is usually tax-free, as are disability insurance benefits. However, there are some exceptions, such as with someone who is also receiving Social Security Disability Insurance (SSDI) or Supplemental Security Income (SSI). If a person is receiving disability and workers’ compensation, then the total received cannot exceed over 80% of their average current earnings. If benefits would exceed this amount, some states will have an offset and reduce the workers’ compensation.
For example, if you are on disability and workers’ compensation, your average earnings are $2,500, and your social security disability insurance is $900. You are also on workers’ compensation at $1,200 totaling $2,100. You would receive $2,000 per month. This amount would exceed your average earnings, subject to income tax. Some taxes have an offset and will reduce the benefits for income tax purposes.
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