The Form 1040 Tax Return: Differentiating Between Income that is Taxable and Income that is Tax Exempt
Taxable Income vs. Nontaxable Income
People sometimes receive money from a variety of sources during any given tax year, and are oftentimes confused as to which inflows are taxable, and which are not. While most income is taxable, there are some sources of funds that are not considered income as such, and you may not have to include income from these sources on your tax return as taxable income.
Taxable income must be reported on lines 7 to 21 of Form 1040, and basically include the following:
- Salaries and wages. This is income you receive from your employment, which is reported to you on a Form W-2.
- Interest income — This represents interest received on deposits with banks, credit unions, and any other financial institution.
- Ordinary dividends — This represents returns you receive on your stock investments.
- Qualified dividends — This also represents returns you receive on your stock investments, but which is taxed at the lower long-term capital gains tax rate.
- State tax refunds — If you itemize deductions, any state tax refunds you receive is treated as taxable income on the next year’s tax return.
- Alimony received — This is a legal obligation on a person to provide financial support to their spouse before or after marital separation or divorce, and is taxable income in the hands of the recipient.
- Business income — This can be income received as an independent contractor, reported on a Form 1099 Miscellaneous Income statement, or income received from operating a business. This income must first be calculated on a Schedule C.
- Capital gains — A capital gain is a profit realized from the sale of an asset (investment or real estate), directly resulting from an increase in the value of the asset. Long-term capital gains are taxed at a lower rate of tax than ordinary income. Capital gains are figured on a Schedule D.
- Other gains — This represents profits incurred from the sale of your trade or business property. These are reported on Form 4797
- IRA distributions — These represent the taxable portion of your distributions received from your IRA or Roth IRA investments.
- Pensions and annuities — This represents retirement income from your 401k, other retirement instruments, pensions, and annuities.
- Rental income from real estate — This represents net income received from real estate rental, and must first be reported on a Schedule E.
- Royalty income — Represents intellectual property rights income received.
- Income from S Corporations and partnerships.
- Farm income.
- Unemployment compensation.
- Social security income — A portion of this may be taxable, depending on the amount of your combined other income.
- Other income — Any income not falling in any category above is reported as other income.
Tax Exempt Income
Some income, however, will be tax exempt under tax law, and you do not report these on your tax return. Surprisingly to some taxpayers, there are quite a number of income sources that are actually tax exempt, and the more common ones are listed below.
- Life, accident, health, and casualty insurance proceeds, damages for physical injury or sickness, child support, federal tax refunds, interest on state or local government obligations, welfare and other public assistance benefits, workers’ compensation, and similar payments for sickness and injury
- Some benefits provided by your employer are also tax exempt. These include meals and lodgings provided by your employer (if the meals are furnished on your employer’s business premises, and the lodging is required for employment), employee achievements awards, and employer contributions to a medical savings account.
- Your Social Security benefits can be totally tax exempt if you have no other income. However, if you have other income, only a part will be tax exempt, and this will depend on the level of your other income.
- Most veterans’ benefits are also tax exempt, including veterans’ disability benefits and military allowances.
- Most education assistance program benefits are tax exempt; your employer must exclude from your taxable income, the first $5,250 of any qualified educational assistance paid to you each year.
- Part of scholarships and fellowship grants received may be tax exempt, but only a candidate for a degree program can qualify for this exemption.
- Housing allowances for members of the clergy are tax exempt, also are gifts, bequests, inheritances, and disaster relief grants.
If you are in doubt as to whether income from a particular source is taxable or not, it would be a good idea to give the IRS a call for clarification.