Breakdown of Taxable vs. Non-Taxable 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 (IRS) 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 2021
The IRS generally taxes all forms of earned income—anything received in exchange for money, services, or property. That’s a wide net. As of 2021, it includes—but is not limited to—these sources:
- 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, especially when it comes to more complicated sources of income like fringe benefits.
All of 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 Non-taxable Income in 2021
Non-taxable income in 2021 includes:
- Needs-based public assistance, including Supplemental Security Income
- Public welfare fund or 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 Dec. 31, 2018
- Inheritances (although inheritances of more than $11.7 million may be taxable to the estate)
- Gifts (although gifts totaling more than $15,000 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 even if you do have to make note of them there, they should not be subject to tax.
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 like 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. 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 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
There are some tactics you can employ 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 in 2021 if you’re under age 50, and up to $7,000 if you’re age 50 or older. This increases to $19,500 for 401(k)s and $26,000 if you’re age 50 or older. 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 72. You don't have to wait until age 72, although you’ll pay a 10% penalty if you do so before age 59 1/2 (except in special circumstances).
In non-retirement investment accounts, 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.