Sources of Tax-Free Income and Nontaxable Side Jobs
Most income is taxed, whether earned or received as a return on investment. In addition, when you sell anything for more than its base price (usually the amount you paid for something), you have to pay income tax.
If you receive taxable income, it makes no difference whether you get it in cash, by check or electronic payment, or in the form of products or services. You still have to pay taxes on it.
However, certain forms of income are tax-exempt. This often includes money you or someone else has previously paid taxes on, as well as income from unusual circumstances, such as combat pay.
So, let’s understand what is meant by taxable income and non-taxable income, tax-free income, and non-taxable side jobs.
What Is Taxable Income?
Taxable income is defined by the Internal Revenue Code as gross income minus deductions. And, according to federal law, "gross income" includes "all income from whatever source generated." That covers a wide range of areas, including not just earned income such as wages, but also income received as a return on investments. If you operate on a cash-free basis, the value of products received as a barter transaction is also taxed.
The IRS doesn't care where your money comes from, directly stating, "Income from unlawful activities, such as money from distributing illegal drugs, must be reported in your income on Schedule 1 (Form 1040), line 21, or on Schedule C (Form 1040) if from your self-employment activity."
The most common types of taxable income include:
Wages, salaries, and gratuities. Your employer is required by law to provide you with a W-2 form that indicates how much you were paid:
- Salary
- Commissions
- Tips
- Bonuses
- Sick pay
- Vacation pay
- Severance pay
The extra money from side jobs or small businesses. Any extra income earned from multiple jobs through the gig economy or your small business is taxed and is considered self-employment income. This revenue should be reported on Schedule C. If your side income is more than $400, you must submit a Schedule SE and pay employment taxes on the income.
Pensions and annuities. Pensions and annuities are taxed. However, some portion of it is tax-free.
Awards. If your company gives you an award for your job performance, it is usually taxed. The fair market value (FMV) of the award is reflected in your W-2 income. This can include an all-expenses-paid trip or other products and services.
What Is Non-Taxable Income?
Non-taxable income is income that is earned but is not subject to taxes. Even though such sources of remuneration cannot be taxed, they must be included in your income tax return. Non-taxable income examples include gifts, inheritance, cash refunds on purchases, etc.
What Are Tax-Free Income Examples?
Here are a few examples of tax-free income that Uncle Sam's tax collector does not get to keep.
1. Educational Aid From Your Boss
You can deduct up to $5,250 in qualifying employer-provided educational aid from your income.
2. Adoption Assistance From Your Employer
If your employer pays some of the cost of adopting a child, it is typically not taxable income. For the 2021 tax year, the tax-free employer-paid adoption aid was $14,440 per child. In 2022, it's $14,890. The amount you can deduct is determined by your modified adjusted gross income.
3. Child Support
Child support payments are not taxed.
4. Compensation for Childcare
Government payments to foster parents for the care of children who have been placed in their homes are often tax-free income.
5. Compensation for Workers
If you get benefits for a work-related illness or accident under federal or state law, the money is tax-free. However, if a portion of your worker's compensation affects your Social Security or railroad retirement benefits, that portion may be taxed. Also, if you return to work on light duty, your wage payments can be taxed.
6. Life Insurance Proceeds
When you get them as a result of the death of the insured individual, the sum is normally not taxable. There are certain exceptions, see IRS Publication 525 for further information.
7. Some Canceled Debts
If a lender cancels a debt you owe, you may be eligible to deduct it from your gross income if the loan was canceled in a bankruptcy case, while you were insolvent, was qualifying agricultural debt, debt linked with a qualified real property business was intended as a gift, or was for your house. There are exceptions and specifics to consider, so ensure to check IRS Publication 525.
8. Subsidies for Energy Conservation
You upgraded your home's air conditioning system and got a rebate from your electric service provider as a reward for your energy-saving efforts. That financial owing, either as a direct or indirect subsidy for the purchase or installation of a home energy conservation measure, is generally tax-free income.
9. Interest on Municipal Bonds
The interest you earn on state and local government bonds is often not taxed. Even better, if you buy municipal bonds issued by your own state, the interest is typically not taxed at the state level.
10. Gifts
Financial gifts, whether in the form of money or other assets, are not taxed. If a federal gift tax is due on the present, the giver is responsible for paying it.
11. Inheritance
There is no federal inheritance tax, so anything your great-uncle left you should not cause any immediate tax problems. However, if he left you an asset that generates income, like a dividend-paying stock, you may be required to pay tax on the money earned by the gift.
12. Accelerated Death Benefits
If you get death benefits from a life insurance policy or viatical settlement as a result of being terminally or chronically sick, you may be allowed to deduct the money from your income.
13. Disaster Relief Payments
If you are a victim of a specific disaster, you can usually exclude money received from the government or a transportation carrier to pay for personal expenditures, burials, house repairs, and property replacements that insurance does not cover.
14. Some Roth IRA Withdrawals
You can withdraw your Roth IRA contributions — the money you put in, not the profits — whenever you choose, without penalty or tax, regardless of how long your account has been open. This is due to the fact that the money you put in has already been taxed.
Maybe, maybe not. In some situations, one sort of payment may be tax-free, while another, very identical payment may result in a tax bill. Here are three situations in which you must be extremely cautious.
Some legal settlements are tax-free, while others are not. Consider what the payment replaces and why it was given to decide whether you owe the US Treasury a portion of your court award. For example, proceeds for emotional hardship or mental agony caused by a personal bodily accident or illness, are generally tax-free. However, punitive damages imposed by a court are taxable, even if they were given as part of a settlement for personal physical injuries or sickness.
If Social Security is your sole source of income, it is tax-free. However, if you have other sources of income, such as a part-time job, side gig, a taxable pension, or investment profits, you may be required to pay federal income tax at your regular tax rate on up to 85% of your federal government retirement plan.
Home-sale proceeds are untaxable income for many as long as it is less than a specific amount: $250,000 for a single seller and $500,000 for a married couple filing jointly. However, if you make a killing capital gains in real estate, the IRS will collect tax on the amount you pocket that exceeds those levels.
Remember that your personal circumstances, such as the amount of additional money you make through a side hustle, may have an impact on seemingly tax-free conditions on some occasions.
So, if you get the money that you believe is tax-free, double-check it. IRS Publication 525 contains information on taxable and nontaxable income. A tax professional can guide you through all of the factors.
Is It Taxed if I Give My Employee a Gift?
Employer financial gifts, like cash or gift cards, are normally considered fringe benefits, not gifts, and are taxable income.
However, a modestly valued infrequent gift, such as a Christmas fruitcake, is deemed a de minimis fringe benefit and is not taxed.
The Bottom Line
The IRS's default view is that all income is taxed. However, you should not assume that all of your income is subject to taxation, the tax legislation offers hundreds of tax deductions for this norm. Planning with tax preparers to lawfully take advantage of such exclusions may enable you to live a more fulfilling life.