What Is Considered Untaxed Income? A Detailed Look

The United States operates under a comprehensive income tax system where most earnings, such as wages, salaries, investment returns, and business profits, are subject to federal taxation. However, not all financial inflows are considered taxable income by the Internal Revenue Service (IRS). “Untaxed income” refers to specific types of income not included in gross income for federal income tax purposes under current law. This means recipients do not owe federal income tax on these amounts. Understanding untaxed income is important for managing personal finances.

Types of Income Not Subject to Tax

Certain financial inflows are explicitly excluded from gross income. These exclusions often serve specific public policy goals, such as promoting education, assisting those in need, or encouraging certain types of savings.

Gifts and Inheritances

Gifts and inheritances are generally not subject to income tax for the recipient. Property or money received as an inheritance is usually not considered taxable income to the beneficiary. While the recipient does not pay income tax, the donor of a gift may be subject to gift tax if the value exceeds certain annual exclusion amounts. Similarly, an estate might be subject to estate tax, which is levied on the total value of the deceased person’s assets before distribution to heirs. These are distinct from income tax on the recipient.

Certain Welfare and Government Benefits

Many government benefits designed to promote the general welfare are not subject to federal income tax. This includes payments from programs such as the Supplemental Nutrition Assistance Program (SNAP) and certain housing assistance. These benefits are based on need and are not considered compensation for services. The underlying principle for excluding these payments is the “general welfare exclusion,” which applies to legislatively provided social benefit programs. This administrative exception acknowledges that these payments are for the public good.

Qualified Scholarships and Fellowships

Scholarships and fellowship grants can be untaxed if they meet specific criteria. For a degree-seeking candidate at an eligible educational institution, amounts used for qualified education expenses are not taxable. Qualified expenses include tuition, fees, books, supplies, and equipment required for courses. However, any portion of a scholarship or fellowship used for incidental expenses like room and board, travel, or non-required equipment is taxable. If the scholarship represents payment for services, such as teaching or research, that portion is usually considered taxable income.

Health and Accident Insurance Payments

Payments received from health and accident insurance policies for medical care or for permanent injury or sickness are not subject to federal income tax. This exclusion applies to reimbursements for medical expenses and payments for the permanent loss or loss of use of a body part or function. This also extends to certain long-term care insurance payments and employer-provided health insurance benefits. Distributions from a Health Savings Account (HSA) used for qualified medical expenses are also tax-free.

Gain from Sale of Primary Residence

Individuals can exclude a significant amount of gain from the sale of their primary residence from gross income under Section 121. A single taxpayer can exclude up to $250,000 of gain, while married couples filing jointly can exclude up to $500,000. To qualify for this exclusion, the taxpayer must have owned and used the home as their principal residence for at least two of the five years preceding the sale. This exclusion can be used once every two years.

Child Support Payments

Child support payments received by a custodial parent are not considered taxable income. The parent making child support payments cannot deduct them from their income. This tax treatment reflects the purpose of child support, which is to provide financial assistance for the child’s upbringing. Federal law views these payments as a personal expense.

Return of Capital

A return of capital occurs when an investor receives back a portion of their original investment, rather than a profit or gain. This is not considered income and is not immediately taxable. Instead, a return of capital reduces the investor’s cost basis in the investment. Once the adjusted cost basis is reduced to zero, any subsequent distributions are considered a capital gain and become taxable. This concept applies to various investments, including certain distributions from mutual funds or partnerships.

Certain Municipal Bond Interest

Interest earned on bonds issued by state and local governments, known as municipal bonds, is often exempt from federal income tax. This tax-exempt status makes municipal bonds attractive to investors, particularly those in higher tax brackets. While federally tax-exempt, some municipal bond interest may be subject to the Alternative Minimum Tax (AMT). Interest from municipal bonds issued by a state other than the investor’s state of residence may be subject to state and local taxes.

Qualified Disability Payments

Certain disability payments are not subject to federal income tax. This includes disability compensation and pension payments received from the Department of Veterans Affairs (VA) for service-connected disabilities. Similarly, workers’ compensation payments for occupational sickness or injury are tax-free at both federal and state levels. However, if a portion of workers’ compensation reduces Social Security or railroad retirement benefits, that part may become taxable.

Differentiating Untaxed Income from Other Tax Concepts

Untaxed income is excluded from gross income, meaning it is not considered part of the taxpayer’s total income for federal tax calculations. This differs from taxable income, which encompasses most earnings unless specifically exempted by law. Taxable income is the amount on which income tax is ultimately calculated after deductions and exemptions.

The term “tax-exempt income” is often used interchangeably with untaxed income, particularly for items like municipal bond interest. While the effect is the same—no federal income tax is owed—”tax-exempt” often refers to income explicitly made exempt by statute. Untaxed income can be a broader category encompassing items excluded through administrative interpretation or specific provisions.

In contrast, “tax-deferred income” refers to income not taxed in the current period but subject to taxation later, typically upon withdrawal. Common examples include earnings within traditional retirement accounts like 401(k)s and Individual Retirement Accounts (IRAs). While contributions to these accounts may be deductible, and earnings grow tax-free, distributions in retirement are generally taxable. This differs from untaxed income, which is never taxed.

Deductions and credits are mechanisms that reduce a taxpayer’s overall tax liability, but they do not render the underlying income untaxed. Deductions, such as those for student loan interest or traditional IRA contributions, reduce a taxpayer’s adjusted gross income (AGI), thereby lowering the amount of income subject to tax. They reduce the amount of income that is taxable, not make the income itself untaxed. Tax credits directly reduce the amount of tax owed, dollar for dollar. While credits provide a direct tax savings, they apply to the calculated tax liability rather than defining the income as non-taxable in the first place. Neither deductions nor credits change the fundamental nature of the income received; they simply adjust the final tax bill.

Reporting Requirements for Informational Purposes

Even if certain types of income are not subject to federal income tax, there may be requirements to report these amounts to the IRS for informational purposes. This reporting helps the IRS track financial transactions, verify the untaxed status of income, and collect data for statistical analysis. Informational reporting does not imply taxation; it ensures transparency and compliance with tax regulations.

For instance, while the recipient of a gift does not pay income tax on it, the donor may have reporting obligations. If an individual makes gifts totaling more than the annual gift tax exclusion amount to any one person in a calendar year, they are required to file Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. For 2024, the annual exclusion is $18,000 per recipient, increasing to $19,000 for 2025. This form reports the gift but does not necessarily mean gift tax is owed unless the lifetime exclusion amount (e.g., $13.61 million for 2024, $13.99 million for 2025) has been exhausted.

Similarly, inheritances are not income-taxable to the beneficiary. However, the executor of a deceased person’s estate may need to file an estate tax return (Form 706) if the gross estate’s value exceeds the federal estate tax exemption amount.

The sale of a primary residence, even when the gain is excluded from income under Section 121, may still trigger informational reporting. If the sale involves a real estate closing, the closing agent or attorney might be required to report the transaction to the IRS on Form 1099-S, Proceeds From Real Estate Transactions. This form provides the IRS with details of the sale, allowing them to verify the exclusion claimed by the homeowner.

Individuals with foreign financial accounts may have reporting requirements even if the income generated in those accounts is untaxed by the U.S. This includes filing a Report of Foreign Bank and Financial Accounts (FBAR) with the Financial Crimes Enforcement Network (FinCEN) if the aggregate value of foreign financial accounts exceeds $10,000 at any point during the calendar year. This reporting ensures the U.S. government has information about offshore assets, regardless of their taxability.