Employees typically pay taxes on income as they receive it, whether it comes in the form of money, property, or services. However, some types of income are exempt from taxation, meaning they get to keep more of their earnings. Appropriately, this income is called nontaxable income.
Nontaxable income examples include:
- Certain disability wages
- Insurance premiums paid by the employer
- Life insurance payouts
- Inheritance and gifts
- Income earned in a state without income tax
- Credit card rewards and points
IRS Publication 525: Taxable and Nontaxable Income details the many kinds of income and whether they are taxable or nontaxable.
What is nontaxable income?
No matter how your employees earn it or its form, their income is usually taxable. In fact, U.S. tax law considers earnings from any source (even an illegal source) as income that will be taxed according to your tax bracket. Moreover, the IRS says that all income is taxable unless specifically exempt by law. When employees file their tax returns, they must report their income on the correct IRS form, such as Form 1040.
Difference between taxable and nontaxable income
Only income specifically exemption by law is considered nontaxable income. So, if the IRS does not specify that a form of income is tax-exempt, it is taxable. While not comprehensive, the below list includes common sources of taxable income.
Salary
Any earned income from work is taxable, including a salary. Employees receive a Form W-2 from their employer detailing their earnings as an employee. Even if they don’t receive a W-2, or if not all of their income is included on the W-2, they have to pay taxes on all their earnings as an employee.
Wages and tips
Even when paid in cash, all wages and tips are taxable. Employees report these earnings in line 1a of Form 1040.
Self-employment income
Any profits derived from personal business activities are taxable at a special self-employment tax rate. Individuals report those profits on Schedule C (Form 1040).
Bonuses and commissions
Any bonuses, awards, winnings, or commissions from outstanding work are also taxable upon receipt, even if the prize is in a non-cash format, like a vacation or car.
Unemployment pay
When compensation from an unemployment benefits program exceeds an individual’s contributions to that program, the excess above their contributions is taxable. However, if an individual deducted their contributions from their tax return as they paid them, all of the unemployment pay is taxable.
Severance pay
All severance pay and any other payments from the cancellation of an employment contract are taxable.
Income from rental properties
If an employer rents property as a business activity for profit, you must report that income on Schedule C (Form 1040). Even if you’re not in the business of renting, you must report any rental income collected on personal property on Schedule 1 (Form 1040), though the way you deduct expenses changes.
12 types of nontaxable income
Wondering what qualifies as nontaxable income? Below, discover the 12 most common types.
1. Disability wages
Nontaxable disability wages include workers’ compensation, supplemental disability insurance, and certain disability pensions for injury resulting from service in the military or government.
Workers’ compensation payments is tax free income, provided a workers’ compensation act distributes them. However, if those payments reduce an employee’s social security/railroad benefits, they may have to pay taxes on that portion.
Disability wages earned from a private supplemental program are considered nontaxable. However, if an employer paid for an employee’s disability pension plan, any payments they receive are taxable. The employee has to report those as wages on Schedule 1 (Form 1040).
If an individual’s disability arose from combat in war or a terrorist attack, their disability payments are nontaxable. Additionally, if disability took them out of active service in the armed forces (of any country), the National Oceanic and Atmospheric Administration, the Public Health Service, or the Foreign Service and they were a member on or before September 24, 1975, their disability benefits are nontaxable.
2. Insurance premiums provided by the employer
If an employer pays premiums for their employees’ insurance, including life or health insurance, or any other kind, those payments are not considered taxable income (even when paid by a third party or a reimbursement agreement). Contributions to employer-provided health savings accounts follow the same rule.
If an employer provides an employee with more than $50,000 of group-term life insurance coverage, then the cost of that life insurance policy that exceeds the cost of $50,000 of coverage is taxable. Calculating the cost of that excess is tricky, so you can tell your employees to refer to IRS Publication 525 for help.
While insurance premiums paid by an employer aren’t taxable, employees’ benefits or payouts from those plans are taxable.
3. Life insurance payouts
Life insurance payouts are nontaxable income for the beneficiary since the deceased individual was the policy owner. Furthermore, if an individual is sick and receives accelerated death benefits as the policy owner, those benefits are often considered tax-free income.
That said, any interest an individual earns on a life insurance payout is taxable. Interest income depends on how they receive the payout, via lump sum or installments.
If an individual receives their payment as a lump sum, the difference between that payout and the value of the payments at the time of death is taxable as interest income. For example, if someone receives $110,000 in a lump sum, but the payments are worth $100,000 at the time of death, the $10,000 excess is taxable.
If an individual receives life insurance proceeds in installments, they must calculate the insurance income on each installment. To do so, divide the total payout by the number of installments to find your excludable amount. Subtract that excludable amount from each payout and record it as taxable income.
For example, if the face value is $100,000 at the time of death and an individual chooses to receive 10 payments of $15,000, the excludable amount is $10,000 ($100,000 ÷ 10). Each time they receive a $15,000 payment, $5,000 ($15,000 – $10,000) is taxable as interest.
If you own an insurance policy on an employee, any payouts greater than the premiums you paid on the policy qualify as taxable income unless the employee gave explicit, written consent to be insured and was an active employee at the time of death.
4. Inheritances
Any property or financial gift given as part of an inheritance or gift is not taxable. Federal law does stipulate that some bequests are subject to federal taxes if the number goes over a certain amount (currently $12.92 million).
However, if someone earns income on an inheritance or gift via interest or rent, that income is taxable as part of capital gains when earned.
5. Child support
While alimony payments are taxable income for the recipient (for divorces after 2018), child support payments (and the Child and Dependent Tax Credit) are not. In general, the divorce or separation agreement specifically designates which payments are child support. For help determining whether a payment is alimony or child support, see IRS Publication 504: Divorced or Separated Individuals.
6. Welfare and other public assistance benefits
Any needs-based public welfare payments constitute nontaxable income. This income includes payments from the state to the victims of crimes, work-training programs, and disaster relief/mitigation payments.
Disaster relief payments qualify as nontaxable income only if they’re federally declared or result from terrorist or military action. While nontaxable disaster mitigation payments often come after a disaster, state and local governments issue them to prevent future disasters, so they’re not held to the same criteria as relief payments.
If an individual receives a disaster relief payment, but their insurance has already paid their expenses, any excess above those expenses is taxable income.
7. Foster care payments
If someone receives qualified payments to assist in caring for a foster child, those payments are nontaxable annual income. However, that income is taxable if the individual cares for more than five qualified foster children above the age of 19. If you provide foster care as a business, any assistance payments are taxable.
8. Energy conservation subsidies
If a utility provider pays a subsidy or rebate when they install new energy-saving equipment, that subsidy is nontaxable income.
9. Profit from sale of home
If an individual sells their home, the first $250,000 of the proceeds from the sale are nontaxable. That amount increases to $500,000 they file taxes jointly with a spouse. The home they sold must have been the taxpayer’s primary residence for two or more of the last five years to qualify for this special exemption.
10. Roth IRA distributions
If an employee elects to defer their after-tax income into a retirement plan program—whether that’s a 401(k), 403(b), or an IRA—they designate those contributions as Roth. Then, the IRS considers any future qualified distributions from those Roth retirement accounts as nontaxable income. However, if they deferred income into their retirement account pre-tax (which is common), then any qualified withdrawals from those accounts are taxable.
11. Long-term care insurance benefits
Any payouts from a long-term care insurance policy are nontaxable, even if an individual deducted the premiums or those premiums were paid by their employer. The insurance contract must meet specific requirements, as outlined in IRS Publication 525.
Per diem payments are nontaxable up to a daily limit of $420 per day in 2023 unless the cost of care exceeds that amount. Any amount above $420 (or above the cost of care if it exceeds $420) is taxable income.
12. Interest on municipal bonds
When an individual purchases municipal savings bonds to support public infrastructure and financing in their state, any interest earned on those bonds is nontaxable.
Which states have a nontaxable income?
Certain states do not tax individual income at all. While paying federal income tax is mandatory, some states don’t require additional income taxes.
The following do not have state taxes:
- Alaska
- Florida
- Nevada
- South Dakota
- Tennessee
- Texas
- Washington
- Wyoming
FAQs around nontaxable income
Is social security nontaxable income?
While social security benefits are typically nontaxable income, they are subject to special tax rules. Employees with significant additional income on top of their benefits often pay taxes on up to 85 percent of their benefits.
To determine if a benefit is taxable, your employee will first calculate their “combined income” by adding together their gross income, nontaxable interest income, and half of their social security benefits, if applicable. If they file individually and their combined income is greater than $25,000 but less than $34,000 ($32,000 to $44,000 if filing jointly), 50 percent of their benefit is taxable that tax year. If the combined income is greater than $34,000 ($44,000 if filing jointly), 85 percent of that benefit is taxable.
What types of gifts are never taxable?
In general, any gift exchanged between individuals is nontaxable to the recipient. The donor is the one who pays the gift tax.
Donors are also exempt from the gift tax if the gift is under the exclusion limit ($17,000 in 2023), is a tuition/medical expense payment, or is given to a spouse, political organization, or qualifying charity. Note that unlike many other gift types, donations to qualifying charities are generally tax deductible.
Any gift where full consideration is given in return is not considered a gift and is taxable income to the recipient. Gifts given by an employer (such as fringe benefits) are also taxable unless they are non-cash holiday gifts.
Is nontaxable income gross income?
Nontaxable income is excluded from your gross income on IRS Schedule 1 (Form 1040). You often still have to report your nontaxable income on your tax return, but not as gross income. IRS Publication 525 details which kinds of income are nontaxable and how to report them on your tax return. If an individual accidentally pays excess taxes on nontaxable income, the government reimburses those funds through their tax refund.
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