As a small business owner, when tax season arrives each year, you may feel a mix of dread, apprehension, and stress, but it doesn’t have to be this way. You can ease these symptoms by gaining a clearer understanding of what you owe for taxes on the income you’ve worked hard earning all year.
In 2017, Americans paid nearly $1.66 trillion in individual income taxes alone. So before you send your portion of the annual collection in, it’s a good idea to know what income might be tax-free. That knowledge will help you keep more of your hard-earned income in your own pocket.
What Is Considered to Be Taxable Income?
The easiest way to understand what income is taxable is to know that, in general, all income is taxable unless it is specifically excluded by law. We’ll discuss those exclusions in detail later. First, let’s look at some different types of taxable income:
- The most common type of taxable income is employee compensation. That includes wages, salaries, commission, tips, and more. This income is generally reported on Form W-2 from your employer.
- If you own a business, you likely receive business income. Businesses add up their revenue from sales, and then subtract the cost of those sales, operating costs, and general administrative costs. Whatever is left over at the end is taxable income. If the business is a pass-through organization like a partnership, S corporation, LLC, or sole proprietorship, then that income flows through to the owner’s personal tax return. On the other hand, a C corporation has its income taxed at the company level.
- You may earn rental income if you rent out property such as equipment, vehicles, or real estate.
- You may receive royalty income from copyrights, patents, or oil, gas, or mineral rights.
- Investment income includes interest, dividends, capital gains and other types of distributions from bank accounts, stocks, bonds, mutual funds and various other types of investments.
- Retirement income includes taxable distributions from IRAs, pensions and 401(k) plans. Retirees may also receive Social Security benefits, which may be taxable depending on how much income they receive from other sources.
The list above is not exhaustive, but they’re some of the most common forms of taxable income you may receive.
What Types of Income Are Not Taxable?
You can’t avoid taxes—well, easily or legally, that is. This is because all income is typically taxable. But, as mentioned above, there are a few types of income that are specifically excluded. Here’s a look at some examples of income that is usually not taxable:
- Tax-exempt interest. Municipal bonds are investment products that earn tax-exempt interest. If you own or invest in municipal bonds that earn tax-exempt interest, you should receive a 1099-INT that reports your tax-free earnings.
- Child support payments. Child support payments are not considered taxable income.
- Alimony. Before 2018, alimony was considered taxable income to the recipient and a deductible expense of the payer. This remains true for alimony paid under divorce agreements signed on or before December 31, 2018. Alimony paid under divorce agreements made after that date are not taxable income for the recipient or deductible for the payer.
- Gifts. In general, gifts are not taxable. However, the IRS puts a cap on the amount of money a person can gift to another person by establishing yearly and lifetime limits. For 2018, the annual exclusion is $15,000 and the lifetime exclusion amount is $11,180,000.
- Inheritances. Inherited money or property is typically not taxable. However, if you receive money from the sale of inherited property, that may be taxable income.
- Welfare benefits. Benefits paid out by the government to individuals based on needs are not considers taxable for federal income tax purposes. This includes Supplemental Nutrition Assistance Program (SNAP), Temporary Assistance for Needy Families (TANF), and Women, Infants, and Children (WIC) benefits.
- Damage awards for physical injury or sickness. If you receive a settlement for personal physical injuries or physical sickness, that income is generally not taxable. However, if you claimed a deduction for medical expenses related to the injury or sickness in prior years, a portion of your settlement may be taxable. Also, if a portion of the settlement was for lost wages, lost profits from a business, or punitive damages, that portion of the settlement is taxable.
- Cash rebates. Cash back credit card rewards and cash rebates on products you buy are considered to be price adjustments, not income. Thus, they are not taxable.
- Life insurance proceeds. According to the IRS, “Generally, life insurance proceeds you receive as a beneficiary due to the death of the insured person, aren’t includable in gross income and you don’t have to report them.” However, if you redeem a life insurance policy for cash, any amount that is more than the cost of the policy is taxable.
- Scholarship money. Scholarships received and used for costs such as tuition and required course books are not taxable. However, if you receive scholarships to pay for room and board and other expenses, the money is taxable income.
Do You Have to Report Nontaxable Income?
Whether or not you need to report nontaxable income depends on the type of income you receive. Tax-exempt interest must still be reported on your federal income tax return. The tax-exempt portion should be included on the 1099-INT you receive from your bank or brokerage.
If you receive a gift, even if it is above the exemption limits mentioned above, you do not have to report the gift on your return. Reporting gifts and paying any applicable gift tax is the responsibility of the giver. The giver should file Form 706 for gifts over the annual or lifetime exemption limits.
Most other types of tax-exempt income do not need to be reported.
What Investments Are Tax Free
Typically, you invest your money to grow your financial assets, but taxes on your investments can reduce your financial growth significantly. The higher your income, the more taxes will cut into your investment returns. To avoid this, you can consider tax-free investments such as:
- Municipal bonds. These bonds are a common tax-free investment choice. Municipal bonds are debt securities issued by states, cities, towns, or counties to finance projects like construction of highways or bridges. When you buy a municipal bond, you are lending money to the jurisdiction that issued it. You will be paid a specific amount of interest payments over a certain amount of time in exchange for lending the money. Interest from municipal bonds is exempt from federal income taxes and may be tax exempt for state income tax purposes.
- 529 plans. These plans are administered by states, state agencies, or educational institutions. When you put money in these funds—designed to be used for higher education expenses—they grow tax free. They’re a tax-advantaged way for parents to save for their child’s college because, so long as the money is used for qualified higher education expenses, withdrawals from the plan are tax-free.
- 401(k) retirement plan. This is a company-sponsored retirement plan. Contributions to the plan reduce your taxable income now and the earnings in this account are not taxed until you begin withdrawing from the plan. This can be an advantage if you’re in a lower tax bracket when you retire.
- Roth Individual Retirement Accounts (IRAs). While there is no tax break for the contributions you make to a Roth IRA, the earnings from these accounts can be withdrawn tax-free in retirement.
- Gifting stock. If you are considering making a charitable contribution, you may be able to save on taxes by giving a gift of appreciated stock. Rather than selling the stock, paying tax on your gains, and then making the donation, you simply gift shares in the stock. You’ll avoid paying capital gains taxes but may be able to claim a deduction for the fair market value of the stock at the time of the gift.
What Are Three Items That Are Not Taxable?
In addition to the nontaxable incomes mentioned above, there are a few more items to consider that are tax free. They include:
- Most healthcare benefits. According to the IRS, when employers pay for an employee’s health insurance plan, this is not considered to be a part of wages. Therefore, the benefits are not subject to Social Security, Medicare, Federal Unemployment Tax Act (FUTA) taxes, or federal income tax.
- Reimbursements for qualified adoption expenses. If your employer offers a qualified adoption assistance program for its employees, adoption benefits paid either directly to you or to a third party may be excluded from your taxable income.
- De minimis fringe benefits. Your employer may offer certain perks to employees to keep them happy and engaged. These are de minimis fringe benefits and do not have to be included in your taxable income. These include occasional snacks, coffee and doughnuts, etc., occasional tickets to sporting events, holiday gifts, occasional meals while working overtime, small gifts such as flowers, fruit, or books, and more.
Can a Gift Be a Tax Write-Off?
While we’ve already mentioned that you may be able to receive a tax deduction for gifting stock to charity, there are some other rules for deducting gifts you might want to be aware of:
- Gifts to individuals. Ordinarily, you cannot claim a deduction for gifts you make unless it is a charitable contribution made to a tax-exempt organization. A common pitfall taxpayers run into is donating to crowd-sourced fundraising campaigns for individuals. For example, a local family loses their home to fire, so a friend sets up a fundraising page asking for donations to help the family get back on their feet. If you donate to the family, it is considered a personal gift and you cannot claim a deduction.
- Medical expenses paid for someone else. Typically, you can only claim a deduction for medical expenses paid for yourself, your spouse, or any dependents. However, you may be able to claim a deduction for medical expenses paid for someone else, such as an elderly parent in a nursing home or an adult child. There are special rules and income thresholds to navigate, so it’s a good idea to talk to a tax professional before claiming such a deduction.
- Business gifts. If you own a business and give gifts to your clients, you may be able to claim the gift as a business expense. However, deductions for business gifts are limited to no more than $25 per person.
This tax season, don’t get caught off guard while filling out your tax return. Keep track of your income from all sources and research which types of income are tax free. Leaving taxable income off of your return can come back to bite you in the long run and you could end up having to pay additional taxes and penalties if the IRS selects your return for audit. If you’re not sure whether something qualifies as income, it’s worth spending a few bucks to consult a tax professional. Some sound advice could save you money in the long run.
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What is the minimum income that is not taxed? For example, if you get income for one source of income less than a certain amount, then what is that amount under which you can not get taxed? Also you may not need a 1099 or 1098?
You get taxed on all income reported on 1099s, 1098s and W-2. I think the best way to determine what’s the minimum that wouldn’t be taxed is to look at the tax tables (link below) and figure out what your taxable income would be after taking either the standard or itemized deduction.
https://www.nerdwallet.com/article/taxes/federal-income-tax-brackets
Hope that answered your question!
Are VA disability paid to widow taxable?
Disability benefits you receive from the Department of Veterans Affairs (VA) aren’t taxable. You don’t need to include them as income on your tax return. Tax-free disability benefits include: disability compensation and pension payments for disabilities paid either to veterans or their families.
We know that the stimulus checks are tax free for the year they’re issued, does this tax exempt status extend to any interest or profit earned from the original stimulus money. If that money was deposited into an account and a proper paper trail was formed and then that money was invested, would the future profits from the investments also be and remain income tax exempt?
Hi Robert, interest, gains and dividends from the proceeds while invested would be taxable.
That is nice to know that there are bonds that are tax-exempt. It would be nice to have a tax free bond. Then I would be able to earn interest without worrying about taxes.
What about kids inheriting upon the death of their parent a substantial coin collection, silver and/or gold, all in tangible form?
When stock or real estate are given as gifts, the the cost basis is the original cost basis of the person doing the gifting.
Are short term disability payments tax free?
GREAT READ. What about insurance pay outs for disruption of business, or damage to property?
Thank you, Tricia!
That wasn’t the question. The question was about the cost basis when gifting stocks prior to death.
Heirs receiving stocks and bonds as an inheritance take the assets with a basis (for determining both loss and gain) equal to the fair market value on the date of death of the decedent.
If you gift stock to an individual, not a charity, is the recipients cost basis the original cost basis when the stock was acquired? or the price of the stock the day it was received as a gift. I know in cases of an inheritance, the cost basis is the stock price on the day of death.
I am asking, because I know people who plan to leave stock as an inheritance, but don’t know the actual cost basis of the stock.
what is the status of the Per Diem tax credit for 2018. i can not find anything that talks about it after the new tax codes went into effect.