Breakdown of Taxable vs. Nontaxable Income
Not every dime you might receive is considered taxable income
Income derives from numerous sources—it’s not just that paycheck your employer hands over to you periodically. The Internal Revenue Service pretty much wants its share whenever money changes hands, whether it’s for services rendered or due to savvy investment choices.
If you have money today that you didn’t have yesterday, it’s usually taxable, but “usually” is the operative word here. Some money does escape the tax net.
Sources of Taxable Income in 2018
The IRS says that that income is anything received for “money, services or property.” That’s a wide net indeed. As of 2018, it includes—but is not limited to—these sources:
- Employee fringe benefits
- Employee bonuses and awards
- Employer’s contributions made to an unqualified retirement plan
- Disability retirement payments from an employer-paid plan
- Employer-paid sickness and injury payments from certain plans
- Commissions, including those paid in advance
- Severance pay
- Unemployment compensation
- Compensation for lost pay received via lawsuit
- Rental income
- Royalty payments from oil, gas, or mineral properties, as well as copyrights and patents
- Stock options and dividends
- Capital gains
- Interest, including income generate from offshore accounts
- Self-employment income
- Fair-market value of property received in exchange for services
- Property and services received through barter
- Canceled debts or loans
- Gambling winnings
Employee fringe benefits include gifts valued at more than $25, a portion of employer-paid tuition, use of a company vehicle, and a portion of employer-paid dependent care—but not employer-paid health care benefits. All sources of taxable income from your employer should appear on your W-2 statement, but independent contractors can receive fringe benefits, too, as can business partners.
The IRS says fair market value of property is "the price that it would sell for on the open market. It is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.”
All these forms of income are typically taxable in the year you receive them. If payday is Dec. 31 but you don’t have time to get to the bank to cash or deposit the check until Jan. 2, it’s taxable income in the year that ended on the last day of December. You could have cashed the check on that day—it was in your possession.
An exception to this rule exists if you’re self-employed and use the accrual method of accounting. In this case, you would claim income at the time you earn it regardless of whether you’ve actually received it yet.
Sources of Nontaxable Income in 2018
The IRS does have a bit of a heart. Nontaxable income in 2018 includes:
- Needs-based public assistance, including Supplemental Security Income and welfare
- Public welfare fund or no-fault auto insurance disability insurance payments, or disability benefits for which your employer paid the insurance premiums
- Workers compensation payments
- Employer-provided health insurance
- Life insurance death benefits, but not proceeds when a policy is cashed in
- Child support
- Alimony received under decrees or court orders made after Dec. 31, 2018
- Gifts (although they might be taxable to the giver)
- Lawsuit proceeds representing payment for pain and suffering
- Cash rebates on purchased items
- Most healthcare benefits
- Qualifying adoption reimbursements
- Municipal bond interest
You don’t have to enter most of these income sources on your tax return, but they're still not taxable even if you do.
The full IRS list of untaxable incomes can be found in Publication 525.
Income That Falls Into a Gray Area
If only it were that easy, but tax issues rarely are. A few income sources fall into a “maybe” category.
Scholarships typically aren’t taxable, unless you use the money for something other than tuition, fees, or approved educational expenses. You’ll generally pay taxes on any portion you use for room and board or for that new laptop that wasn’t actually required for any of your courses.
Some employee achievement awards escape the tax net. It depends on what you’re being awarded for. The same goes for nonqualified deferred compensation plans. And if you contribute to certain retirement plans, that money isn’t taxable in the year you do so, but rest assured that the IRS will have its hand out at the time you take distributions. Roth plans are an exception to this rule because you receive no tax break at the time you make contributions. They’re made with after-tax dollars.
A portion of your Social security retirement income might or might not be taxable. It depends on how much other income you have.
It’s best to touch base with a tax professional if you have questions about any of these sources of income because the rules can be complicated.
Tips to Reduce Tax Liability
Now that you know what the IRS wants a piece of and what you can call your own, how can you sway the rules to your favor?
First, remember that many retirement plan contributions aren’t taxable in the year you make them. You can contribute up to $5,500 to a traditional IRA in 2018 if you’re under age 50, and up to $6,500 if you’re age 50 or older. This increases to $18,500 for 401(k)s, and to $24,500 if you’re age 50 or older. You can slice this much off your taxable income now, even if the tax man will be waiting for you later.
Distributions are taxable in the year you take them, and most plans are also subject to required minimum distribution (RMD) laws. These laws can force you to take two distributions in a single year if you’re not careful. That means paying taxes on more income that year than you have to.
You must typically take your first RMD by April 1 in the year after you reach age 70½, then you might have to take another distribution by the end of the year for the current year's distribution. You might consider talking to a tax professional about taking the first distribution in the year you turn age 70½ instead of waiting until after the first of the year. You can even begin taking distributions a bit earlier to stretch the tax burden out over several years. No one says you have to wait until age 70½, although you’ll pay a 10 percent penalty if you do so before age 59½.
You can minimize capital gains taxes by making sure they qualify for long-term rates—don’t sell until you’ve owned assets for at least one year and one day.
And it goes without saying that you’ll want to review the terms of the Tax Cuts and Jobs Act. Some itemized deductions got the ax in 2018, but others are still alive and well and at least one tax credit has been expanded. Make sure to grab every tax break you’re entitled to.