Exempt Income: Definition & Overview

KEY TAKEAWAYS

• Exempt income is a type of income that isn’t subject to tax.
• Tax-exempt income includes gifts, life insurance proceeds, and certain types of investment income.
• Exempt income can be a great way to reduce your tax liability. But it’s important to know the rules so that you don’t inadvertently disqualify yourself from receiving it or other benefits.

What is Exempt Income?

Exempt income, also known as non-taxable income, is any type of income that isn’t subject to income tax. 

Such income is usually earned by workers employed in specific occupations and fields. For example, those who work for the government, qualify for a disability income or receive alimony. 

Non-taxed income can also apply to retirement or annuity payments or repayments on certain types of loans or advances.

What Types Of Income Are Considered Tax Exempted?

The term “exempt income” refers to certain kinds of income that are not subject to taxation. This includes income from certain sources that are exempt from federal, state, and local taxes. 

Exempt income may also refer to income that isn’t included in an individual’s taxable estate upon their death.

The most common type of exempt income is federal, state, and local government benefits. This includes Social Security benefits, veterans’ benefits, and disability payments. Other types of exempt income may include child support payments, alimony, and certain types of investment income.

This type of income isn’t subject to taxation, as it’s considered to be necessary for the recipient’s livelihood. For example, Social Security benefits. They’re exempt because they provide financial assistance to those retired or disabled.

Conversely, some types of income may be partially exempt from taxation. This means that only a portion of the income is subject to tax. For example, if an individual has both taxable and tax-exempt income, they may only tax the taxable portion.

Individuals who have exempt income may still need to file a tax return. This is because other types of taxes, such as self-employment tax, may still apply. Individuals with exempt income may be eligible for certain tax deductions and credits.

It’s important to note that the term “exempt income” does not refer to tax-exempt organizations. These are organizations that are exempt from paying federal taxes on their income. However, they may still have to pay state and local taxes.

The definitions of taxable and tax-exempt income can be complex. As such, it’s always best to consult with a tax professional to ensure that you’re correctly classifying your income.

Depending on the nature of your occupation and how you’re compensated, you may be eligible for one of the following tax exemptions:

Alimony, Child Support, and Spousal Maintenance Payments

Both Alimony and Spousal maintenance payments are taxable to the recipient and might be deductible for the payer. This is true even if these payments are part of a divorce or legal separation agreement.

Child support payments are also not taxable. These payments provide financial support for a child. Thus, they aren’t considered part of a divorce or legal separation agreement.

Spousal maintenance payments are similar to alimony payments. However, these payments provide financial support to a spouse after a divorce or legal separation. And like alimony payments, spousal maintenance payments may be deductible.

Certain Types of Investment Income

Investment income is generally taxable. However, there are some exceptions. For example, interest from certain types of bonds is exempt from taxation. This includes interest from federal, state, and local government bonds. Additionally, private activity bonds may also be exempt from taxation.

Certain types of dividends are also exempt from taxation. This includes qualified dividends and capital gain distributions. Qualified dividends are dividends that meet certain criteria, such as paid by a U.S. company or a company listed on a U.S. stock exchange. Capital gain distributions are profits distributed to shareholders after the sale of a security.

Certain Types of Retirement Income

Retirement income is generally taxable. However, there are some exceptions. For example, distributions from a Roth IRA are not subject to taxation. This is because the contributions to a Roth IRA are already taxed. Additionally, qualified distributions from a traditional IRA may also be exempt from taxation.

Other Types of Exempt Income

Other types of exempt income may include veteran benefits and disability payments. These payments provide financial assistance to those who are unable to work due to a service-related injury or illness. As such, they’re not subject to taxation.

Gifts and Inheritances

Non-taxable gifts can include inheritances and gifts from family members (up to a certain amount). They’re non-taxable because they are not a form of compensation for services rendered.

It’s important to note that some gifts can have a gift tax. You can receive $16,000 in annual gifts before gift taxes trigger. Gift tax ranges from 18% and goes up according to the gift size.

What Qualifies You To Claim Exempt?

There are a few different types of income that qualify you to claim an exemption. The most common type is “earned income,” which includes wages, salaries, tips, and other forms of compensation that you receive for work.

Investment income, such as interest from savings accounts or dividends from stocks can also be qualified for tax exemption claims. Other qualified income can include certain types of government benefits. i.e., Social Security payments, and certain types of pensions.

To claim exempt status, you must file a claim with the IRS on Form W-4. You can claim exemption for a single pay period or for an entire year. If you claim an exemption for a single pay period, you will need to reapply for exempt status each pay period. If you claim exemption for an entire year, you will need to file a new Form W-4 by February 15 of the following year.

The IRS has strict rules about who can claim exempt status. To qualify, you must have earned less than a certain amount of money in the previous year. You must also expect to earn less than that amount in the current year.

You also must not owe any taxes from the previous year, and you must not expect to owe any taxes in the current year. Finally, you must not have claimed exemption from withholding in the previous year.

If you meet all of the criteria for claiming exempt status, you can enjoy the benefits of having more money in your paycheck each week.

However, you should be aware that claiming exempt status also means that you will not have any taxes withheld from your pay. This could put you at risk of owing taxes at the end of the year if your tax exemption situation changes.

What Are The Benefits Of Exempt Income?

When it comes to taxation, there are a couple of key benefits of having your income tax exempt.

The first is that it allows individuals and businesses to keep more of their money. When income is exempt from tax, this means that you won’t have to pay any taxes on it. This can save you a significant amount of money, especially if you have a lot of income that is exempt.

The second benefit of exempt income is that it can help to reduce your overall tax liability. This is because when your income is exempt from tax, the amount of taxes you owe on your other income will get reduced. This can help to lower your overall tax bill and make it easier for you to pay your taxes.

Examples of exempt income

Retirement or Pension Payments

Government pensions and retirement plans such as IRAs qualify as exempt income because they’re savings, not a salary or wage.

Gifts and Inheritances

Gifts and inheritances are non-taxable income because they are not a form of services performed.

Disability Payments

Disability-related payments are non-taxable since you can’t engage in substantial gainful activity.

Alimony

Alimony or spousal support payments are non-taxable if they’re part of your taxable income.

Summary

Exempt income is any income that can’t be taxed. Government pensions and retirement plans such as IRAs are examples of exempt income, as are gifts and inheritances. You may also qualify for an exemption if you receive disability payments or alimony. 

Though exempt income isn’t taxable, it isn’t always free money. It often comes with other restrictions or conditions. And these can affect your eligibility for certain benefits, such as unemployment benefits.

Written by Jami Gong, MPAcc, CPA

Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design. Jami has collaborated with clients large and small in the technology, financial, and post-secondary fields.

Written by Jami Gong, MPAcc, CPA

Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design. Jami has collaborated with clients large and small in the technology, financial, and post-secondary fields.