How Can I Make Tax-Free Money Legally?

It is possible to legally receive or accumulate money without incurring federal income tax, and often state income tax. While most forms of income are subject to tax, specific provisions within tax law allow certain financial avenues to remain untaxed. These opportunities are distinct from tax deductions or credits, which reduce taxable income or tax liability. Instead, they focus on money not considered income for tax purposes initially, or on growth and withdrawals from specific accounts that are exempt under defined conditions.

Tax-Exempt Investment Growth and Withdrawals

Certain investment vehicles offer the advantage of tax-free growth and withdrawals, provided specific criteria are met. These accounts are designed to encourage saving for retirement, healthcare, or education by offering significant tax benefits.

Roth Individual Retirement Arrangements (IRAs) allow contributions to be made with after-tax dollars, meaning the money contributed has already been subject to income tax. The primary benefit of a Roth IRA is that qualified withdrawals in retirement are entirely free from federal income tax. To be considered a qualified withdrawal, the account must generally be open for at least five years, and the account holder must be age 59½ or older, disabled, or the withdrawal is made by a beneficiary after the account holder’s death. For 2025, individuals can contribute up to $7,000 to a Roth IRA, with those age 50 and older allowed an additional catch-up contribution of $1,000, bringing their maximum to $8,000. Eligibility to make full contributions is subject to Modified Adjusted Gross Income (MAGI) limits; for 2025, single filers must have a MAGI under $150,000, and married couples filing jointly must be under $236,000.

Health Savings Accounts (HSAs) offer a “triple tax advantage.” Contributions to an HSA are tax-deductible, reducing current taxable income. The funds within the account grow tax-free, and withdrawals are also tax-free when used for qualified medical expenses. To be eligible for an HSA, an individual must be covered by a high-deductible health plan (HDHP). For 2025, an HDHP must have a minimum annual deductible of $1,650 for self-only coverage or $3,300 for family coverage. The out-of-pocket maximums for these plans cannot exceed $8,300 for self-only coverage and $16,600 for family coverage. The contribution limits for 2025 are $4,300 for self-only coverage and $8,550 for family coverage, with an additional $1,000 catch-up contribution for individuals age 55 and older.

Section 529 plans are designed for educational savings, allowing funds to grow tax-free and to be withdrawn tax-free when used for qualified education expenses. While contributions to 529 plans are not federally tax-deductible, many states offer tax deductions or credits for contributions. Qualified education expenses are broad and include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. Room and board expenses also qualify if the student is enrolled at least half-time. Additionally, up to $10,000 per year per student can be used for K-12 tuition, and up to $10,000 in lifetime student loan repayments per individual can be made tax-free from a 529 plan. Non-qualified withdrawals are subject to federal income tax on the earnings portion and typically a 10% federal penalty tax.

Direct Tax-Free Income Streams

Several types of direct receipts or income streams are generally not subject to federal income tax for the recipient. These exclusions are specifically outlined in tax law, allowing individuals to receive these funds without a tax burden.

Gifts of money or property are generally not considered taxable income to the recipient. The responsibility for any potential gift tax typically falls on the donor, not the person receiving the gift. This means an individual can receive gifts of any amount without having to report them as income on their tax return.

Similarly, money or property received as an inheritance is generally not taxable income to the beneficiary. Any federal estate taxes, if applicable, are levied on the estate itself before assets are distributed to heirs, not on the individual beneficiaries receiving the inheritance.

Life insurance proceeds paid to a beneficiary due to the death of the insured person are typically excluded from the beneficiary’s gross income. This general rule applies whether the proceeds are received in a lump sum or in installments. However, any interest earned on the proceeds after the insured’s death, such as when payments are deferred, is usually taxable.

Interest earned on bonds issued by state and local governments, known as municipal bonds, is often exempt from federal income tax. This exemption applies to interest received from public purpose bonds. Furthermore, if the bond is issued by a government entity within the bondholder’s state of residence, the interest may also be exempt from state and local income taxes. This dual exemption makes municipal bond interest an attractive option for tax-free income.

Specific Exempt Benefits and Compensation

Certain benefits and forms of compensation are specifically excluded from taxable income under various tax code provisions. These exclusions often relate to situations involving injury, illness, or educational pursuits, providing financial relief without an associated tax obligation.

Payments received as workers’ compensation for occupational sickness or injury are generally fully exempt from federal income tax. This applies to benefits received under federal or state workers’ compensation laws. The intent of these payments is to compensate for lost wages and medical costs due to a work-related incident.

Certain disability benefits can also be tax-free, depending on how the insurance premiums were paid. If an individual pays the entire cost of their health or accident insurance plan, any disability benefits received from that plan are generally not included in their income. However, if an employer pays the premiums for a disability insurance plan, the disability payments received by the employee are typically fully taxable. Additionally, benefits received from the Department of Veterans Affairs due to a service-connected disability are tax-free.

Qualified scholarships and fellowships can be tax-free for degree candidates to the extent they are used for tuition, fees, and course-related expenses like books, supplies, and equipment. Amounts received for other purposes, such as room and board, travel, or other non-qualified expenses, are considered taxable income. The tax-free portion is limited to educational costs directly related to enrollment and instruction.

Compensation received for personal physical injuries or physical sickness is generally excluded from gross income. This includes damages received, whether through a lawsuit settlement or agreement, that are directly attributable to physical injuries or physical sickness. For example, payments for medical bills, pain and suffering directly related to a physical injury, and emotional distress caused by a physical injury are typically non-taxable. However, punitive damages, which are awarded to punish the at-fault party, are always taxable as ordinary income. Damages for lost wages or emotional distress not directly tied to a physical injury are also generally taxable.

Tax-Free Capital Gains from Home Sales

A significant tax benefit exists for homeowners selling their primary residence, allowing them to exclude a substantial amount of capital gains from taxation. This provision encourages homeownership by reducing the tax burden on profits from a home sale.

The Internal Revenue Service (IRS) allows qualifying homeowners to exclude up to $250,000 of capital gains from the sale of their main home if filing as single. For married couples filing jointly, this exclusion doubles to $500,000. This exclusion applies to the profit made on the sale, not the total sale price of the home.

To qualify for this exclusion, homeowners must satisfy both an ownership test and a use test. The ownership test requires that the taxpayer must have owned the home for at least two years (730 days or 24 full months) during the five-year period ending on the date of the sale. The use test dictates that the taxpayer must have used the home as their main home for at least two years during the same five-year period. The two-year periods for ownership and use do not need to be continuous or immediately precede the sale.

The exclusion can generally only be claimed once every two years. This means that if a homeowner has already excluded gain from the sale of another home within the two-year period prior to the current sale, they typically cannot claim the exclusion again. There are exceptions for unforeseen circumstances, such as changes in employment or health, which might allow for a reduced exclusion even if the two-year rule is not met.