What Is Exempt Income?
I want you to understand that exempt income is simply income that's not subject to income tax. You might encounter types of income exempt from federal or state taxes, or both. The IRS sets the rules for what's exempt from federal income tax and under what conditions. States have their own definitions for exempt income, so check those too.
Key Takeaways
Remember, exempt income means no taxation applies to it. Some income could be exempt at the state level but still taxed federally. Think about income from investments like municipal bonds—that qualifies as exempt. Also, distributions from Roth 401(k)s and Roth IRAs are tax-exempt. Benefits like employer-sponsored supplemental disability insurance and most from health insurance plans are exempt from taxes.
Understanding Exempt Income
You should know that certain income and benefits are nontaxable in specific situations. For health-related benefits, things like employer-sponsored supplemental disability insurance bought with after-tax dollars are tax-exempt. The same goes for private insurance plans funded that way, most employer-sponsored health insurance benefits, and worker's compensation.
The Tax Cuts and Jobs Act of 2017 got rid of personal exemptions for tax years 2018 to 2026, but it roughly doubled the standard deduction. For 2024 and 2025, here are the standard deductions: singles and married filing separately get $14,600 in 2024 and $15,000 in 2025; married filing jointly get $29,200 in 2024 and $30,000 in 2025; heads of household get $21,900 in 2024 and $22,500 in 2025.
When filing taxes, you choose between the standard deduction or itemizing. Itemized deductions include medical expenses, mortgage interest, and charitable donations.
Examples of Exempt Income
Take distributions from health savings accounts—they're exempt from income tax only if used for qualified medical expenses. Qualified distributions from Roth 401(k) plans and Roth IRAs, funded with after-tax dollars, are tax-exempt.
Interest from municipal bonds is exempt from federal and state income tax if you live in the issuing state. If someone passes away and you're the beneficiary of life insurance, that's nontaxable income too.
What Does Exempt Mean?
Exempt means free from something. In taxes, tax-exempt means free from taxes.
What Types of Income Are Tax Exempt?
Income from municipal bonds and distributions from Roth 401(k)s and Roth IRAs are tax-exempt. Also, income from employer-sponsored benefits like supplemental disability insurance and most health insurance plans are exempt.
Is Unemployment Income Taxed?
The federal government treats unemployment benefits as ordinary income, but not all states tax them. Taxation depends on the program providing the benefits.
The Bottom Line
Most income like wages, salaries, and tips is taxable, but some isn't. Exempt income includes Roth retirement distributions, municipal bonds, and certain benefits. Keep this in mind for your taxes.
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