The government says that all types of income are taxable unless specifically excluded by law.
Income That Isn’t Taxed includes the following :
1. Disability Insurance Payments
Usually, disability benefits are taxable if they come from a policy with premiums that were paid by your employers. However, there are many other categories of disability benefits that are nontaxable.
- If you purchase supplemental disability insurance through your employer with after-tax dollars, any benefits you receive from that plan are not taxable.
- If you purchase a private disability insurance plan on your own with after-tax dollars, any benefits you receive from that plan are not taxable.
- Workers’ compensation (the pay you receive when you are unable to work because of a work-related injury) is another type of disability benefit that is not taxable.
- Compensatory (but not punitive) damages for physical injury or physical sickness, compensation for the permanent loss or loss of use of a part or function of your body, and compensation for your permanent disfigurement are not taxable.
- Disability benefits from a public welfare fund are not taxable.
- Disability benefits under a no-fault car insurance policy for loss of income or earning capacity as a result of injuries are also not taxable
2. Employer-Provided Insurance
The IRS says that “generally, the value of accident or health plan coverage provided to you by your employer is not included in your income.” This could be health insurance provided through your employer by a third party (like Aetna or Blue Cross) or coverage and reimbursements for medical care provided through a health reimbursement arrangement (HRA). Furthermore, employer and employee contributions to a health savings account are not taxable. Employer-provided long-term care insurance and Archer MSA contributions (a type of medical savings account) are also not taxable.
3. Gift Giving ; Gift Receipt of Any Amount
Just as the IRS defines all income as taxable, except that which is specifically excluded by law, it defines all gifts as taxable, except those specifically excluded by law. Thankfully, there are many gifts that aren’t taxable, and any tax due is always paid by the gift-giver, not the recipient.
Perhaps the most well-known exclusion is that individuals can gift up to a certain amount per donor per year without the gift being taxable. For example, each member of a married couple could give each of their three children $13,000 in 2010. The parents would gift a total of $78,000, and none of that gift would be taxable for either the parents or the children. Each child would receive $26,000 of nontaxable income.
The following types of income are also considered nontaxable gifts:
- Tuition or medical expenses paid on someone else’s behalf
- Political donations
- Gifts to charities (charitable donations) – in fact, these are tax-deductible, meaning that they reduce your taxable income by the amount of the donation. (Learn more in It Is Better To Give AND Receive.)
An important exception to this rule is gifts from employers. These gifts are usually considered fringe benefits, not gifts, and are taxable. A small gift worth less than $25, such as a holiday fruitcake, is an exception to the fringe benefit rule.
To prevent tax evasion, the IRS also says that the gift tax applies “whether the donor intends the transfer to be a gift or not.” For example, if you sell something at less than its market value, the IRS may consider it a gift. An accountant can provide you with tax-planning advice to help you avoid triggering the gift tax and let you know when you should file IRS form 709, United States Gift (and Generation-Skipping Transfer) Tax Return.
4. Life Insurance Payouts
If a loved one dies and leaves you a large life insurance benefit, this income is generally not taxable. However, be aware that there are some exceptions to this rule in more complex situations. IRS publication 525: Taxable and Nontaxable income, describes these exceptions.
5. Sale of Principal Residence
Individuals and married couples who meet the IRS’s ownership and use tests, meaning that they have owned their home for at least two of the last five years and have lived in it as a principal residence for at least two of the last five years, can exclude from their income up to $250,000 (for individuals) or $500,000 (for married couples filing jointly) of capital gains from the sale of the home.
6. Municipal Bond Interest
Most of the time, when you invest in bonds, you have to pay federal, state and/or local tax on the yield you earn. However, when you earn money from municipal bonds, the proceeds are usually tax-free at the federal level and also tax-free at the state level if you live in the same state the bonds were issued in. This tax exemption applies whether you invest in individual municipal bonds or purchase them through a municipal bond fund.
Although municipal bonds generally offer a lower rate of return than other types of bonds, when you consider their after-tax return, you may end up ahead by investing in municipal bonds. Municipal bonds are generally recommended only for higher-income individuals and married couples who fall into the 28-35% federal income-tax brackets. (Investing in these bonds may offer a tax-free income stream but they are not without risks, see The Basics Of Municipal Bonds.)
Conclusion:
Taxes discourage all activities that are taxed, so why has the IRS chosen to exempt these and a few other sources of income when it generally tries to tax everything? The answer to this question varies, depending on your political views, but for whatever reason, the government has decided to eliminate or dramatically reduce taxes in certain areas to encourage certain activities that it thinks will benefit the country, such as home ownership and investment, and reduce the risks associated with these activities. Why the government taxes the income you earn at work, but not life insurance, is anyone’s guess. (Learn the logic behind the belief that a reducing government income benefits everyone, read Do Tax Cuts Stimulate The Economy?)