11 Sources of Tax-Free Income
There are still ways to earn income that is free from federal income tax. With the various tax changes that have taken effect in recent years, tax-free income opportunities are perhaps more valuable than ever.
Here are 11 sources of non-taxable income, and a bonus.
1. Gifts and Inheritances
If you receive a gift or inheritance, it is generally not taxable. However, if you are given or inherit property that later produces income such as interest, dividends or rent, the income is taxable to you. (There may be gift tax implications for the individual who gives a gift.)
2. Tax-Free Home Sale Gains
In one of the best tax-saving deals, an unmarried seller of a principal residence can exclude (pay no federal income tax on) up to $250,000 of gain, and a married joint-filing couple can exclude up to $500,000 of gain. There are some limitations. You must pass the following four tests to qualify.
Ownership Test. You must have owned the property for at least two years during the five-year period ending on the sale date.
Use Test. You must have used the property as a principal residence for at least two years during the same five-year period (periods of ownership and use need not overlap).
Joint-Filer Test. To be eligible for the maximum $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test.
Previous Sale Test. If you excluded gain from an earlier principal residence sale, you generally must wait at least two years before taking advantage of the gain exclusion deal again. If you are a married joint filer, the $500,000 exclusion is only available if neither you nor your spouse claimed the exclusion privilege for an earlier sale within two years of the later sale.
3. Life Insurance Proceeds
Life insurance death benefits paid to you as the beneficiary of a policy on another person's life are generally free from federal income tax.
4. Economic Impact Payments (EIPs)
To mitigate the financial effects of the COVID-19 pandemic, the federal government sent EIPs to eligible individuals in 2020 and 2021. In order to be eligible, your income had to be below certain thresholds. If you received EIPs, the payments aren't included in your gross income. Therefore, you don't owe federal income tax on the payments.
5. Qualified Roth IRA Withdrawals
Roth IRAs are still a great tax-saving deal and can provide tax-free income. Roth accounts have two big tax advantages.
The first Roth advantage is tax-free withdrawals. Unlike traditional IRA withdrawals, qualified Roth IRA withdrawals are free from federal income tax (and usually state income tax). What is a qualified withdrawal? In general it is one that is taken after the Roth account owner has met both of the following requirements:
He or she has had at least one Roth IRA open for over five years. He or she has reached age 59 1/2, is disabled or is dead.
The second Roth advantage is an exemption from the required minimum distribution rules. Unlike with a traditional IRA, the original owner of a Roth account (the person for whom the account is originally set up) is not burdened with the obligation to start taking required minimum distributions (RMDs) after age 72 or face a 50% penalty. Therefore, you can leave a Roth account untouched for as long you live. This important privilege makes the Roth IRA a great asset to leave to your heirs (to the extent you don't need the Roth IRA money to help cover your own retirement-age living expenses).
Side Note: Making Annual Roth IRA ContributionsAnnual Roth IRA contributions make the most sense for people who believe they will pay the same or higher tax rates during retirement. Higher future tax rates can be avoided on earnings because qualified Roth withdrawals are free from federal income tax (and usually state income tax).
The downside is you get no deductions for Roth contributions. So if you expect to pay lower taxes during retirement, you might be better off making deductible traditional IRA contributions (assuming your income is low enough to get a deduction), because the current deductions may be worth more to you than tax-free withdrawals later on.
Contributions are limited, earned income is required, and high earners may not be eligible. The maximum amount you can contribute for any tax year to a Roth IRA is the lesser of:
Your earned income for the year, or The annual contribution limit for the year. Earned income includes wages, salary, bonuses, taxable alimony received and self-employment income.
For 2021, the annual Roth contribution limit is $6,000 ($7,000 if you're age 50 or older as of year-end). The eligibility to make annual Roth contributions is phased out when modified adjusted gross income (MAGI) reaches certain levels. Consult with your tax advisor.
Key Point: If your MAGI is too high for Roth contributions, consider converting a traditional IRA into a Roth account. No income restriction. Everyone is eligible for Roth conversions, regardless of their MAGI. That's important because conversion contributions are the only way to quickly get large amounts of money into a Roth IRA. Keep in mind that conversions trigger taxable income in the year of conversion. Consider the federal income tax (and potentially state tax) that will accompany a conversion and consult with your tax advisor before acting.
6. Qualified Section 529 Withdrawals
The biggest advantage of 529 college savings plan accounts is they are allowed to accumulate earnings free of any federal income taxes. When the account beneficiary (typically a child or grandchild) reaches college age, federal-income-tax-free withdrawals can be taken to cover his or her qualified higher education expenses. State income tax breaks are often available too.
Helpfully enough, contributions to a 529 account will also reduce your taxable estate because they are treated as gifts to the account beneficiary. Contributions in are eligible for the $15,000 annual federal gift-tax exclusion. Contributions up to the exclusion amount won't diminish your unified federal gift and estate tax exemption ($11.7 million in 2021).
If you're feeling really generous, you can make a larger lump-sum contribution to a 529 account and elect to spread it over five years for gift-tax purposes. This allows you to immediately benefit from five years' worth of annual gift-tax exclusions while jump-starting the beneficiary's college fund. You make the five-year spread election by filing the IRS gift-tax return form.
Example: You're unmarried and can make a 2021 lump-sum contribution of up to $75,000 (5 times $15,000) to a Section 529 account set up for a child, grandchild, or another person you want to help. If you're married, you and your spouse can together contribute up to $150,000 (2 times $75,000). Lump-sum contributions up to these amounts won't diminish your unified federal gift and estate tax exemption as long as you choose to take advantage of the five-year spread privilege. If you want to help several children or grandchildren, you can run the same 529 account drill for each one.
If you want (or need) to get your money back from a 529 account, it's allowed under the tax rules. You can take back all or part of the account balance. You'll owe taxes on any withdrawn earnings plus a penalty equal to 10% of the withdrawn earnings. However, that's a relatively small price to pay for the right to reverse a contribution decision, if desired.
7. Qualified Coverdell Education Savings Account Withdrawals
If you're not such a high roller when it comes to tax-free college savings opportunities, you also have the option of contributing up to $2,000 annually to a Coverdell Education Savings Account (CESA) set up for a beneficiary (typically a child or grandchild) who has not yet reached age 18. A CESA is an account set up by a "responsible person," which means you, to function exclusively as an education savings vehicle for the account beneficiary.
CESA earnings are allowed to accumulate federal-income-tax-free. Then, tax-free withdrawals can be taken to pay for the beneficiary's college tuition, fees, books, supplies, and room and board. If you have several beneficiaries in mind, you can contribute up to $2,000 annually to separate CESAs set up for each one.
Here's the catch: The right to make CESA contributions is phased out if your modified adjusted gross income (MAGI) reaches certain levels.
However, this restriction can often be circumvented by enlisting someone who is unaffected by the income limitation. For example, you can give the contribution dollars to a trustworthy adult who can then open up the CESA as the "responsible person" and make a contribution on behalf of your intended beneficiary. Keep in mind that when the "responsible person" is someone other than yourself, your control over the account is lost.
8. Tax-Free Rebates for Purchases
A cash rebate received from a retailer, dealer or manufacturer for an item you buy isn't taxable income. However, you have to reduce your tax basis by the amount of the rebate. For example, you buy a new car for $28,000 and the manufacturer sends you a $2,000 rebate check. Although the $2,000 isn't taxable income, your tax basis in the car is reduced to $26,000. That basis number is used to calculate gain or loss when you sell the car or depreciation if you use it for business purposes.
9. Tax-Free Long-Term Capital Gains and Dividends
The current federal income tax rate on net long-term capital gain and qualified dividends is 0% when they fall within the 0% rate bracket for these types of income, based on your taxable income level (including the net long-term gain and qualified dividends). A surprising fact is you can have a pretty healthy income and still qualify for the 0% rate on some or all of your net long-term gain and dividends.
Key Point: Taxable income is after subtracting any "above-the-line deductions" that are allowed whether you itemize or not. These write-offs include deductible IRA and self-employed retirement account contributions, health savings account contributions, self-employed health insurance premiums, and alimony payments required under pre-2019 divorce agreements. If you claim the standard deduction, it reduces your taxable income. If you claim itemized deductions, the total also reduces your taxable income. All these deductions increase the odds that some or all of your net long-term capital gain and qualified dividends will qualify for the 0% federal income tax rate.
10. Tax-Free Scholarships
Payments received from a qualified scholarship are normally not taxable. Amounts you use for certain costs, such as tuition and required course books, are not taxable. However, amounts required to be used for room and board are taxable.
11. Tax-Free Court Awards and Damages
Compensatory awards and judgements for personal physical injury or physical sickness (received in a lump sum or installments) are free from federal income tax. However, punitive damages are taxable. Awards for unlawful discrimination or harassment are also taxable. If you receive a court award or out-of-court settlement, consult with your tax advisor about the tax implications.
BONUS: Prorated Home Sale ExclusionIf you don't qualify for the maximum $250,000 or $500,000 gain exclusion due to failure to pass all the tests explained here, you may still qualify for a prorated (reduced) exclusion amount if you had to sell your home for job-related or health reasons or for certain other IRS-approved reasons.
Example: You're a married joint filer. You and your spouse owned and used a home as your principal residence for only 18 months before having to move for health reasons. You qualify for a prorated exclusion of $375,000 (18/24 x the $500,000 maximum allowance for a joint-filing couple).
There is a lot to think about in this piece, especially regarding Roth IRA conversions. If you have questions about how to effectively safeguard your financial security or those of a family member or friend, please give me a call at 480-513-1830, or schedule a time to chat via my calendar, Chat With Charles.
Source: Hunter Hagen and Company, LTD, October 2021