Breakdown of Taxable vs. Non-Taxable Income

Not every dime you might receive is considered taxable income

Woman sitting at kitchen table calculating income on a computer

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Income isn't just that paycheck your employer hands over to you periodically. It derives from numerous sources. The Internal Revenue Service (IRS) pretty much wants its share whenever money changes hands, whether it's for services rendered or due to savvy investment choices.

It's usually taxable if you have money today that you didn't have yesterday, but "usually" is the operative word here. Some money does escape the tax net.

Key Takeaways

  • The IRS considers income to include any money earned by any means, with rare exception.
  • Most forms of income are typically taxable in the year you receive them.
  • Income that is not taxable includes but is not limited to public assistance or welfare grants, alimony and child support, death benefits, gifts and inheritances up to a limit, and more.
  • In some cases, scholarships, certain retirement plans, and Social Security income may avoid taxation, but there are many exceptions.
  • There are a number of strategies you can use to reduce your tax liability, particularly in areas of retirement distributions and capital gains.

Sources of Taxable Income in 2021

The IRS generally taxes all forms of earned income—anything received in exchange for money, services, or property. That's a wide net. It includes but isn't limited to these sources as of the 2021 tax year, the tax return you'd file in 2022:

  • Wages
  • Salaries
  • Tips
  • Employee fringe benefits (such as a car)
  • 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 a 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 generated from offshore accounts
  • Self-employment income
  • The fair market value of property received in exchange for services
  • Property and services received through barter
  • Canceled debts or loans
  • Gambling winnings

All sources of taxable income from your employer should appear on your W-2 statement, but it's a bit trickier for independent contractors and business partners. This is especially the case when it comes to more complicated sources of income like fringe benefits.

All these forms of income are typically taxable in the year you receive them. If payday is December 31, but you don't have time to get to the bank to cash or deposit the check until January 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 because it was in your possession.

An exception to this rule exists if you're self-employed and use the accrual method of accounting. You would claim income at the time you earn it in this case, regardless of whether you've actually received it yet.

Sources of Non-taxable Income in 2021

Non-taxable income in the 2021 tax year includes:

  • Needs-based public assistance, including Supplemental Security Income
  • Public welfare fund, no-fault auto insurance disability insurance payments, or disability benefits for which your employer paid the insurance premiums
  • Worker's 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 December 31, 2018
  • Inheritances (although inheritances of more than $11.7 million may be taxable to the estate as of tax year 2021, increasing to $12.06 million in 2022)
  • Gifts (although gifts totaling more than $15,000 might be taxable to the giver as of tax year 2022, increasing to $16,000 in 2022)
  • 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. Still, they should not be subject to tax even if you have to make note of them there.

Income That Falls into a Gray Area

Not all income sources are clearly taxable or non-taxable. Some 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 strictly required for any of your courses.

Some employee achievement awards escape the tax net. It depends on factors such as the type and value of the award. The same goes for non-qualified deferred compensation plans. If you contribute to certain retirement plans, that money isn't taxable in the year you do so, but the IRS will tax your distributions when you take the money out later. Roth plans are an exception to this rule because you receive no tax break at the time you make contributions.

A portion of your Social Security retirement income may or may 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

You can use some tactics to tweak your tax situation a little more to your benefit.

First, remember that many retirement plan contributions aren't taxable in the year you make them. You can contribute up to $6,000 to a traditional IRA if you're under age 50 and up to $7,000 if you're age 50 or older in tax years 2021 and 2022. This increases to $20,500 for 401(k)s in 2022 (up from $19,500 in 2021) and $27,000 if you're age 50 or older in 2022 (up from $26,000 in 2021).

You can slice this much off your taxable income now, but the IRS 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, which means paying taxes on more income than you have to.

You must typically take your first RMD in the year you turn age 72. You don't have to wait until age 72, but you'll have to pay a 10% penalty if you do so before age 59 1/2, except in special circumstances.

You can minimize capital gains taxes in non-retirement investment accounts 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.

Article Sources

  1. Internal Revenue Service. "Publication 525, Taxable and Nontaxable Income."

  2. Internal Revenue Service. "What is Taxable and Nontaxable Income?"

  3. Internal Revenue Service. "Publication 5307: Tax Reform Basics for Individuals and Families," Page 1.

  4. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2022."

  5. Internal Revenue Service. "Grants, Scholarships, Student Loans, Work Study."

  6. Internal Revenue Service. "Publication 15-A: Employer's Supplemental Tax Guide," Page 11.

  7. Internal Revenue Service. "Traditional and Roth IRAs."

  8. Social Security Administration. "Income Taxes and Your Social Security Benefit."

  9. Internal Revenue Service. "Retirement Topics—IRA Contribution Limits."

  10. Internal Revenue Service. "2022 Limitations Adjusted as Provided in Section 415(d), Etc." Pages 1-2.

  11. Internal Revenue Service. "Retirement Plan and IRA Required Minimum Distributions FAQs."

  12. Internal Revenue Service. "Retirement Topics - Exceptions to Tax on Early Distributions."

  13. Internal Revenue Service. "Topic No. 409 Capital Gains and Losses."