Which of Your Income Sources Is Tax-Free?

These 8 Income Sources Aren't Subject to Tax

To hear Benjamin Franklin tell it, nothing in this world is certain but death and taxes. He was almost right. Taxes are pretty much inevitable, at least on income, but there’s a catch. Some revenue streams are not considered income under the U.S. tax code, and if they’re not considered income, they’re not taxed.

Unfortunately, the Internal Revenue Service (IRS) doesn’t provide a nice, comprehensive list of what types of revenue fall into the category of not being income. Instead, tax law somewhat vaguely says that income includes everything that’s not “specifically excluded" in the Code. A little digging is required to identify these income sources. There are actually quite a few of them, although most come with a whole host of intricate rules and conditions. 

Certain Sick Pay and Injury Benefits

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If you call in sick and your employer pays you for the day anyway, this is income. But if you become really sick or you’re injured and you receive benefits from certain disability insurance policies, that revenue source is not income.

The catch here is that you have to be the one who has been paying the premiums on the policy. If your employer foots the bill on your behalf and you then receive benefits, that’s taxable income to you. 

The same applies if you receive benefits from any type of government program that’s not a public welfare fund—they're income. But as long as you write the check every month using after-tax dollars, you’re in the clear while you recuperate. This income is non-taxable.

An exception to this rule is workers’ compensation benefits. It doesn’t matter if your employer pays for workers’ comp insurance or if the government kicks in with benefits. You can collect this source of income tax-free if you’re injured on the job. 

Employee Rewards

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Maybe your boss just realized that you’ve been with the company longer than any other employee. He wants to do something nice for you so he gives you an engraved money clip. The value of tangible property is normally supposed to be included on your Form W-2 as compensation, but employee rewards dodge this rule as long as they’re not given for job performance.

It all comes down to why you’ve received the gift. Because you’re loyal and you come to work every day? That’s not income. Because you work your tail off? That’s taxable income.

There are other rules, too. You can’t exclude from your income an amount that’s more than what your employer paid for the gift, and his cost is capped at $1,600 for the year regardless of how much he actually paid for it. If he paid $2,000, you can exclude $1,600. If he gave you a money clip and another gift totaling $3,000, you can still only exclude $1,600. And if he paid $1,000, you can only exclude $1,000.

Your employer has to present you with the award in a meaningful way. Really. That’s actually a tax rule. He can’t just leave the clip on your desk for you to find when you arrive for work in the morning. If he does, you'll have to pay income tax on its value.

And this exclusion applies only to tangible property. You can’t exclude money, gift certificates, or anything else that you can easily transform into cash, no matter how nicely your employer offers them to you. 

Veterans' Benefits and Some Military Pay

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Former members of the U.S. Armed Forces and even some active servicemen and servicewomen can collect certain forms of income tax-free. Any benefits you receive from the Department of Veterans Affairs are exempt from taxation as long as they’re provided for by law.

If you’re an active member of the military and you receive combat pay, this is tax-free income as well. You don’t still have to be on the battlefield to qualify. This pay is tax-free even if you’re hospitalized due to injuries sustained from your service.

But this exclusion doesn’t apply to all income you receive. It’s limited to hostile fire pay, the highest available rate of enlisted pay, and imminent danger pay. The keyword here is “and.” The total of these amounts is tax-free income unless you’re a commissioned warrant officer. 

Life Insurance Death Benefits

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If you’re Great Aunt Martha’s favorite niece and she names you as the sole beneficiary of her life insurance policy, you can accept the money without worrying about setting any of it aside for income taxes. Death benefits aren’t taxable income, at least not in and of themselves. Of course, there’s a catch.

If Aunt Martha set up her policy so that you receive $1 million in benefits but they’re paid out at the rate of $200,000 a year for five years, any amount that the insurance company holds onto for you over the course of that five-year period will produce interest. That interest is considered income that you have to report on your Form 1040.

If you invest the proceeds and they earn income for you … yes, that capital gain is taxable as well. 

Child Support Payments

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Child support is a tax-neutral event. If you have custody of little Johnny so the court has ordered your ex to pay you $150 a week, this is not taxable income to you. Of course, your ex has to pay taxes on the money when he earns it so the IRS isn’t completely left out in the cold. Dad can’t claim a tax deduction for paying it.

And this money is technically Johnny’s, not yours. It represents what Dad would have contributed financially to his wellbeing if the two of you had stayed together. Johnny doesn’t have to pay taxes on the money either, no more than he would have to if you were all a happy, intact family and Dad gave him an allowance.  

Inherited Money and Gifts

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Gifts can sometimes be taxable … but not as income to the recipient. The benefactor might have to pay a gift tax, but if Aunt Martha gives you $5,000 to pay off your credit card bills, the IRS does not consider that to be income to you. You don't have to report it. 

In fact, Aunt Martha can give you up to $15,000 per year tax-free. That’s the amount of the federal gift tax exclusion per year per recipient as of 2018, so she can give you this much without the hassle of filing a gift tax return and handing a percentage of the gift over to Uncle Sam.

If she wants to be really generous, she can even give you $15,000 on December 31 and $15,000 on January 1 for a total of $30,000 because the gifts take place in different tax years. Of course, she’ll have to wait until the following January to give you anything more.

The same applies if you inherit cash from anyone. That’s still a gift—it just occurs after death. But this is by no means a blanket across-the-board exclusion. It applies to cash. Some other types of inheritances can have tax implications.

For example, if Aunt Martha leaves you a retirement account that’s generating income, that revenue can be taxable to you as “income in respect of a decedent.” This would normally have been her tax responsibility but she’s not here anymore and the account is now yours so you inherit the tax liability as well.  

Compensatory Damages

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Compensatory damages are money you receive from a lawsuit to compensate you for physical or emotional pain and suffering. The IRS says this is tax-free income. But if the judge tacks on punitive damages, making the defendant pay you even more as punishment, this portion of your award is taxable. 

Let’s say you walk out to your mailbox at the curb one night to collect your mail. Your neighbor is driving intoxicated and he misjudges the distance to his own driveway and turns into you instead. You’re grievously injured and you sue him.

The jury awards you $500,000 for your pain and suffering. That’s tax-free income. The judge awards you another $500,000 to teach your neighbor a lesson—that he should never drive drunk again. This part is taxable income to you.

And if you’re also awarded $125,000 for a year’s lost wages because you couldn’t work while you recovered, this is taxable income as well. If you hadn’t been injured, you would have collected taxable earnings for the same amount. 

Public Assistance

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Most types of public assistance are non-taxable income. If you collect welfare, you don’t have to pay taxes on that money. The same applies to SSI—Supplemental Security Income—and all other needs-based programs. You’re receiving this money because your earning potential is such that you could not survive without it. This provision also includes Medicare Part A and Part B benefits.

It does not automatically apply to Social Security retirement benefits. Social Security is not a needs-based program. It’s based on your work record over the years, and it’s possible that some portion of these benefits could be taxable depending on how much other income you have.

The Rules Can Be Tricky

This list is by no means comprehensive is just a summary of the rules that apply to each of the exclusions mentioned. If you think you fall into one of these categories, check with a tax professional before you decide not to include the income on your tax return. Make sure you have a firm understanding of the rules, and if it turns out that your income source is indeed tax-free, enjoy it.