Understanding what counts as taxable income and what does not can significantly impact your financial planning and tax obligations. The IRS has specific guidelines about examples of taxable and nontaxable income that every taxpayer should know. While most money you earn is subject to taxation — like wages, salaries, bonuses and business profits — there are surprising exceptions that could save you money when tax season arrives. Certain types of income may be partially taxable or completely tax-free, such as some Social Security benefits, certain life insurance proceeds and qualified scholarships. Knowing these distinctions can help you make informed financial decisions and potentially reduce your tax burden.
A financial advisor can help you with your own tax planning, especially as it relates to your investments.
Taxable Income Examples
Understanding what counts as taxable income is essential for proper financial planning and tax compliance. While the IRS has specific rules about what you must report on your tax return, many taxpayers remain uncertain about which types of income are subject to taxation. This is a look at common examples of taxable income.
1. Earned Income
Earned income represents the most common form of taxable income for most Americans. This category includes wages, salaries, tips, commissions and bonuses that you receive from employment or self-employment activities. Employers typically withhold federal and state income taxes from your paycheck, which is itemized on your pay stub.
Any compensation you receive for providing services counts as earned income. This includes traditional employment arrangements where you receive a W-2 form at the end of the year, as well as independent contractor work reported on 1099 forms. Even cash tips you do not report to your employer are legally taxable income that you must report on your tax return.
2. Unearned Income
Unearned income refers to money received from sources other than employment or business activities. This category includes interest earned from savings accounts, certificates of deposit and bonds. The IRS considers these passive earnings as taxable, requiring you to report them on your annual tax return even if you did not actively work to generate this money.
Dividends from stocks represent another common form of unearned income. When companies distribute profits to shareholders, these payments typically count as taxable income. Income from rental properties constitutes unearned income that is generally taxable. This includes payments received from tenants for residential or commercial properties you own. Unemployment benefits, despite being government assistance, count as taxable unearned income in most circumstances.
3. Retirement Distributions
Most retirement account distributions count as taxable income when you receive them. Pre-tax dollars fund raditional 401(k)s and IRAs, meaning you will pay ordinary income tax when you withdraw in retirement. These distributions are reported on your tax return and taxed at your current income tax rate, which could be different from when you made the contributions.
Not all retirement withdrawals trigger a tax bill. Qualified distributions from Roth IRAs and Roth 401(k)s are completely tax-free since you have already paid taxes on the contributed funds. To qualify, the account must be at least five years old and you must be at least 59½, disabled or using up to $10,000 for a first-time home purchase.
4. Prizes or Gambling Winnings
When fortune smiles upon you at the casino or you win that radio contest, the IRS wants to share in your good luck. Prizes and gambling winnings are considered taxable income, so you must report them on your tax return. Whether you hit the jackpot on a slot machine, won a car on a game show or received a cash prize for a contest, these windfalls are generally subject to federal income tax.
For professional gamblers who make their living this way, different rules apply. You may report gambling income as self-employment income, but this is potentially subject to additional self-employment taxes. However, they may also deduct gambling-related expenses that casual gamblers cannot.
5. Canceled Debt
If a lender forgives or cancels your debt, the IRS typically considers that write-off to be income you have received. Lenders who forgive debts of $600 or more must send you a Form 1099-C detailing the amount of canceled debt, which you will need to include when filing your taxes.
Not all canceled debt triggers a tax bill. Certain situations qualify for exclusion, including bankruptcy discharges, insolvency and qualified principal residence indebtedness in some cases. Some student loans may also qualify if forgiven after working in specific professions.
Examples of Nontaxable Income
While many forms of income are subject to taxation, there are several types of income that the IRS does not require you to report on your tax return. Understanding these examples of nontaxable income can help you better manage your financial planning and potentially reduce your tax burden.
1. Gifts or Inheritances
When you receive money or property as a gift or inheritance, this is generally not taxable income. The IRS specifically excludes these types of windfalls from your income tax obligations, providing a significant financial benefit during what might be an emotionally challenging time.
The person giving the gift is typically responsible for any potential gift tax implications. Currently, individuals can give up to $19,000 per recipient annually without triggering gift tax reporting requirements. This means you can receive multiple gifts from different people without worrying about income tax consequences on these amounts.
2. Some Government Benefits
Benefits paid to veterans and their families typically remain nontaxable. This includes disability compensation, pension payments, education and training assistance and housing grants for disabled veterans. The government recognizes the service and sacrifice of military personnel by ensuring these benefits remain free from federal income tax obligations.
3. Workers’ Compensation Benefits
Workers’ compensation benefits provide financial support to employees who suffer job-related injuries or illnesses. These benefits typically cover medical expenses, rehabilitation costs, and a portion of lost wages during recovery periods. The good news for recipients is that workers’ compensation benefits are generally not subject to federal income tax.
While most workers’ compensation benefits remain nontaxable, certain situations may create exceptions. If you simultaneously receive Social Security Disability Insurance (SSDI) and workers’ compensation, a portion of your benefits might become taxable. Additionally, if you return to light-duty work while still receiving partial benefits, your regular wages remain taxable as normal income.
4. Life Insurance Proceeds
When a policyholder passes away, the death benefit paid to beneficiaries is generally not subject to income tax. This favorable tax treatment makes life insurance an important component of many financial plans. The IRS considers these payments to be a return of premium rather than income, allowing families to receive the full benefit amount during a difficult time.
Life insurance proceeds paid as a death benefit are typically exempt from federal income tax. This tax advantage exists regardless of the policy size, whether it’s a $50,000 term policy or a multi-million dollar permanent life insurance contract. The tax-free nature of these benefits helps ensure that the intended financial protection reaches beneficiaries without reduction.
5. Child Support
Child support payments are designed to provide financial assistance for the care and well-being of children after parents separate or divorce. These payments are not considered taxable income by the IRS. This means the parent receiving child support does not need to report these funds on their tax return.
Unlike alimony, which underwent significant tax changes in 2019, child support has consistently remained tax-neutral. The parent making child support payments cannot deduct these payments on their tax return, and the recipient does not count them as income. This tax treatment reflects the principle that these funds are intended solely for the children’s needs.
Bottom Line
Understanding what income is taxable and what is not can significantly impact your financial planning. Overall, the IRS considers most income taxable. However, certain types of income remain nontaxable, such as certain gifts, child support payments and most employer-provided health insurance benefits. By properly categorizing your income and understanding what the IRS expects you to report, you can confidently navigate tax season while remaining compliant with federal tax regulations.
Tips for Tax Planning
- Proper tax planning takes time and expertise. A financial advisor can help you with both your tax and investment planning. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- You may want to utilize an income tax calculator if you’re trying to estimate how much tax liability you could have in the next year.
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