Exempt income is income that isn’t taxed. You don’t have to give your state or the federal government a percentage of it. Such income is usually spared from taxation because giving taxpayers this type of break serves the greater good in some way. For example, exempt income could encourage individuals to save for retirement so they don’t become a financial drain on the economy in their later years.
But the line between exempt income and taxable income can be vague. The rules aren't necessarily the same for both the federal and state tax systems.
Definition and Examples of Exempt Income
Your income is generally taxable unless a specific law exists to exempt it, according to the IRS. You must include and report income on your tax return, sometimes even if it's exempt. The nature of the income doesn’t matter. It can be in the form of services performed for you, or property transferred to you. It doesn’t have to be cash.
As of 2022, $12,950 of your gross income (from all of your incomes combined) is exempt from federal taxation if you’re single because this is the standard deduction available to single taxpayers (up from $12,550 in 2021). All you have to do is claim it on your return. You can subtract this number—and other sources of exempt income—from your total income so you'll only pay tax on the balance.
How Exempt Income Works
Tax deductions and adjustments to income are used together to arrive at the total amount of your exempt income.
Using the example of the standard deduction, you would pay tax on only $47,450 if your overall gross income was $60,000 in 2021—that is, $60,000 less the $12,550 standard deduction. This assumes that you’re not eligible to claim any adjustments to income, as well. You must choose between itemizing or claiming the standard deduction—you can’t do both—and then you can claim adjustments to income, as well. Adjustments to income appear on Line 10 of the 2021 Form 1040, and your standard or itemized deductions are subtracted two lines later.
Tax deductions are not the same as tax credits. Tax credits subtract from your tax balance when you complete your return—from what you owe the IRS. They don’t subtract from your income.
Types of Exempt Income
The list of adjustments to income and deductions provided under the Internal Revenue Code (IRC) is lengthy, but it shortens considerably if you claim the standard deduction in lieu of itemizing your deductions. Adjustments to income include money you spent on:
- Retirement plan contributions
- Educator expenses, if you’re a teacher
- Health savings account (HSA) contributions
- A portion of your self-employment tax, if you’re self-employed
- Self-employed health insurance costs
- Student loan interest
- Tuition and fees
Itemized deductions include:
- State and local taxes paid, including property taxes
- Home mortgage interest and points paid
- Medical and dental expenses not paid by insurance
- Gifts to charity
- Casualty and theft losses due to a federally declared disaster
These lists of deductions and adjustments to income are not all-inclusive, and each comes with its own set of rules and limitations.
Other exclusions from income include adoption assistance, dependent care benefits, and education assistance paid by your employer on your behalf.
In the past, taxpayers were additionally entitled to claim exemptions for themselves, their spouses, and their dependent children through tax year 2017, but the Tax Cuts and Jobs Act (TCJA) eliminates this provision for tax years 2018 through 2025.
Some types of exempt income are provided for by statutes other than those that establish deductions or adjustments to income. For example, gifts aren't taxable to the recipient as income, although the donor would generally be responsible for paying a gift tax rather than an income tax on a gift’s fair market value.
Then there’s alimony. You once had to include this as income if you received it, but this changed in 2018, as well. It’s now exempt if it's provided for in a divorce or separation agreement entered into in 2019 or later. The paying spouse is responsible for paying income tax on that money, although it may be deductible. The same applies to child support: It’s not taxable to the parent receiving it.
States Have Their Own Rules
To further complicate the issue, states additionally have their own laws for exempt income. For example, New Jersey exempts unemployment compensation, workers’ compensation, and Social Security benefits. But up to 85% of your Social Security benefits might be subject to income tax at the federal level depending on your financial circumstances.
Types of Taxable Income
As generous as the IRS might appear to be about exempting certain income, it does not exempt money from certain sources that you might think aren’t taxable. This includes fringe benefits provided by your employer in some circumstances. It also includes royalties, some disability pension income, and “income” derived from bartering.
Here’s how the last instance might work. Maybe your neighbor is an electronics whiz. You’re a plumber. You unclog their kitchen sink, and they repair your ailing hard drive in exchange. Everybody’s happy…except the IRS (unless each of you includes as income the fair market value of the services you received).
How To Report Exempt Income
Unfortunately, the IRS doesn’t allow you to say, “OK, this income is exempt, so I don’t even have to mention it when I file my tax return.” In most cases, the IRS wants to know what income you're exempting, how much, and why. It effectively has to “approve” your exemptions from income.
This will invariably involve filing one or more additional forms with your Form 1040 tax return. For example, you would have to file Form 8839 if you want to exempt adoption assistance paid by your employer. Excluding dependent care benefits will require filing Form 2441. Adjustments to income must be reported on Schedule 1, and itemized deductions are reported and totaled on Schedule A.
State tax rules for reporting exempt income can differ among states.
The rules for exempt income are complex, and they may not always seem to make sense. Never assume that you don’t have to pay taxes on certain sources of money and simply fail to mention to the IRS that you received it. Consult with a qualified tax professional who can confirm that the income is indeed exempt from taxation and guide you to any forms you must file to corroborate this.
- Exempt income is any portion of your income that you don’t have to pay income tax on.
- This type of income is subtracted from your gross income, so you only pay taxes on the balance.
- Exempt income includes tax deductions, adjustments to income, and other exclusions provided for by law.
- Income is typically exempt from taxation if you spent the money on certain government-approved expenditures, such as saving for retirement.
- You must still report exempt income on your tax return, typically by filing additional forms.
Frequently Asked Questions (FAQs)
Do I have to report exempt income when filing taxes?
Yes. Even if you have income that may be tax-exempt, you still have to report it. You may even need to fill out additional forms, depending on the type of income. Then through the process applying adjustments and deductions, it will be made exempt if it qualifies. The IRS requires that you report all sources of income, regardless of their eventual status on your tax return.
What's the difference between a deduction and an exemption?
Both work to decrease your tax liability, but an exemption excludes some measure of income from the tax calculation altogether, while a deduction is like a concession or grant from the IRS, that subtracts a portion from your gross taxable income once it is calculated.
Can I claim tax-exempt status?
Certain non-profit institutions are tax-exempt, but this designation is not for individual taxpayers.