Taxable vs. Non-Taxable Income: What’s the Difference?
Nothing is as certain as tax season. Like it or not, it comes every year, and taxpayers need to report and pay their dues on all taxable income. But did you know that some income is non-taxable?
That’s right: In some rare cases, Uncle Sam won’t be asking for his fair share. But you may wonder how to know the difference and how you can correctly file your taxes. This guide can help you understand this important distinction.
Read on to learn:
• What is taxable income vs. non-taxable income?
• What are some examples of taxable income?
• What are some examples of non-taxable income?
Taxable and Non-Taxable Income Explained
The difference between taxable and non-taxable income is pretty straightforward:
• Taxable income is subject to taxes. That means you must report it to the IRS on your tax return and pay taxes on it based on your filing status and tax bracket. And remember: Income isn’t just money that you earn. Income can come in the form of money, property, or services rendered.
• Non-taxable income is not subject to taxes. Though you may have pocketed money throughout the year (perhaps child support), you do not need to pay taxes on it. However, you may still need to report it on your tax return.
Understanding the differences between these two terms is easy. It’s understanding just what is considered taxable income vs. non-taxable income that can be more challenging without the help of an accountant.
Understanding your taxes is an important aspect of managing your finances. Incorrectly accounting for income could leave you owing the government money plus penalties, so read on to learn more.
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What Is Taxable Income?
Taxable income is money, property, or services that you received that the IRS requires you to pay taxes on. Common types of taxable income include wages, self-employment earnings, and stock dividends.
Examples of Taxable Income
Wages are an easy example of taxable income, but the list of what kind of earnings are taxed is much more extensive. Below are some examples of taxable income to keep in mind when filing, but note that this list is not exhaustive, meaning you should research each type of income you earned throughout the year to determine if you owe taxes.
• Salary, wages, tips, bonuses, and self-employment income: First and foremost, the income you make for doing your job counts as taxable income. That includes both salaried and hourly workers who receive a W-2. If you earn tips — even cash tips — you’ve got to report those, too. Bonuses are also taxable, as is any income you make as a self-employed individual.
Self-employed taxpayers who receive 1099 forms have to pay more in taxes than salaried employees. That’s because they also owe self-employment taxes to cover items like Social Security and Medicare contributions.
• Investment income: If you rent out property (like a house or a vehicle), you must report that income to the IRS and pay taxes on it. If you have investments that pay interest and unqualified dividends, those are taxable as well.
• Fringe benefits: The IRS is careful to spell out that income isn’t just money you earn. For example, if your employer pays for an off-site gym membership or sends you a Christmas gift every year, these are considered fringe benefits — and you’ve got to report and pay taxes on the monetary value of those benefits. Not all fringe benefits are taxable; if you’re unsure whether you need to pay taxes on something, you can check out the IRS’s resource on fringe benefits or work with an accountant.
• Some retirement income: If you contributed to a traditional IRA or traditional 401(k) plan, those contributions were pre-tax. When you start withdrawing those funds, you unfortunately have to pay taxes on that money.
• Income from the sale of assets: When you sell something — whether it’s your car, a stock, or even an old couch — you generally have to report the capital gain from that sale. There are exceptions, including the big tax break you may receive when you sell your house (more on that below).
• Royalties: If you earn royalties from copyrights, patents, or oil, gas, and mineral properties, you’ll have to pay taxes on those royalties.
• Alimony, sometimes: Tax law on alimony payments has changed. If you got a divorce before 2019 and have not altered the agreement to expressly state that alimony isn’t considered income, then you’ll pay taxes on it.
• Unemployment compensation: Yes, even if you’re out of work and receiving unemployment benefits, you’ve got to pay taxes.
Remember, this list is not all-encompassing. The IRS has guidance on everything from cash for babysitting to bartering to lottery winnings. If you’re unsure what income to report, you may benefit from working with an accountant. As you prepare for tax season, these professionals can help you sort out what is taxable vs. non-taxable income so you can file correctly.
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What Is Non-Taxable Income?
Non-taxable income is money, property, or services that you received that the IRS does not require you to pay taxes on, though you may still need to report it on your tax return. Common types of non-taxable income include child support payments, cash rebates, and welfare payments.
Recommended: What Is Unearned Income?
Examples of Non-Taxable Income
As with taxable income, the list of non-taxable income is extensive (and has a lot of fine print). We’ve compiled some examples of non-taxable income below, but it’s a good idea to work with an accountant if you’re unsure how to report your income on your tax return. Again, this is not a complete list.
• Child support payments: Child support payments are not taxable income — and there’s no fine print to worry about with this money, either.
• Welfare: Welfare benefits are not taxable. Like child support payments, guidance is very straightforward on this.
• Alimony, sometimes: If you receive alimony for a divorce in 2019 or later, you do not pay taxes on that income. If you got a divorce before 2019 and modified the agreement after 2018, you may not have to pay taxes on alimony.
• The sale of a house, sometimes: If you’re quickly flipping houses for a profit, those capital gains are taxable. However, the government has provided a sizable tax break for homeowners. If you sold your home and lived in it for at least two of the last five years, you don’t have to pay taxes on the first $250,000 in profit ($500,000 if married, filing jointly). There’s more fine print about this tax break, so it’s a good idea to reference IRS materials if you have large capital gains from the sale of a house.
• Some fringe benefits: In general, fringe benefits are taxable, but the IRS does have a list of exclusions, like adoption assistance and dependent care assistance (up to certain limits). For full details, review the IRS’s detailed breakdown of fringe benefits and taxation; the link is provided above.
• Some retirement income: While you’ll pay taxes when withdrawing from your traditional IRA and 401(k) in retirement, you won’t have to worry about taxes when drawing from a Roth IRA and Roth 401(k). Why? Contributions are post-tax, so you’ve already paid taxes on the funds.
• Gifts and inheritances: You usually don’t have to pay taxes on (property) gifts you receive; the IRS doesn’t come for Santa’s presents!). What’s more, you likely don’t have to pay taxes on inheritances. Instead, the deceased’s estate pays taxes on the money before you receive the inheritance.
• Life insurance payout: If you receive proceeds as the recipient of a life insurance policy when the policyholder dies, that money is not taxable. But if you cash in a life insurance policy, some or all of it is taxable.
The IRS has a more comprehensive list to review before filing.
Recommended: Different Types of Taxes
The Takeaway
It’s possible to earn both taxable and non-taxable income. While the most common source of income — your paycheck — is taxable, you might receive some income for which you pay no taxes, like child support or capital gains on the sale of your home. It’s wise to make sure you fully understand how money you receive is categorized, so that you can file your taxes correctly. This could be accomplished by working with a tax professional, using tax software, or doing your own research.
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FAQ
What are the pros and cons of taxable income?
The largest pro of taxable income is that it inherently means you’re making money. Whether it’s from a salary or an investment, having income that’s taxable implies you are receiving the money you need to survive. And, of course, the con of taxable income is that not all of the income is yours — you’ll have to pay taxes on it, and generally, the more you earn, the more you’ll owe.
What are the pros and cons of non-taxable income?
The biggest pro of non-taxable income is that you don’t have to pay taxes on it. Every dollar you earn is yours to keep. Non-taxable income can have some cons, however, depending on the source. For example, you may receive non-taxable income as a life insurance payout or inheritance, which implies you’ve lost someone special in your life. Non-taxable income can also be more confusing to navigate on your tax return and could necessitate the help of a professional accountant.
How do you calculate taxable and non-taxable income?
The IRS has a comprehensive guide to taxable vs. non-taxable income. In assessing each source of your income, you can review IRS guidance for how to report it and whether it’s taxable or not. If you’re feeling overwhelmed, you may benefit from using tax preparation software or a professional tax preparer.
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