What Sources of Income Are Not Taxed by California?

While a substantial portion of income is subject to taxation, specific sources are often designated as exempt. These exemptions exist at both federal and state levels, reflecting various policy objectives, such as promoting certain activities or providing financial relief. This article aims to clarify which specific income sources are not subject to taxation by the state of California.

Understanding California’s Tax Approach

California’s income tax system generally aligns with federal tax law regarding the definition of what constitutes income. However, it maintains its own distinct set of rules, resulting in notable differences and specific state-level exemptions. Income is broadly presumed to be taxable in California unless a specific legal provision explicitly excludes it from taxation. This principle means taxpayers must demonstrate that an income source qualifies for an exemption under state law.

The California Franchise Tax Board (FTB) is the state agency responsible for administering and collecting personal income tax and corporate franchise and income tax. This agency oversees compliance with California’s tax code, which has a progressive personal income tax system with rates varying based on income levels. While California often conforms to the Internal Revenue Code (IRC) with modifications, it does not automatically adopt all federal changes.

Income Exempt from Both Federal and California Tax

Certain income sources are not subject to income tax at either the federal or California state level, offering a complete exemption for recipients. These exemptions are typically established due to the nature of the income, often involving compensation for specific losses, support payments, or transfers of wealth.

Gifts are generally not considered taxable income to the recipient, regardless of the amount. The federal government imposes a gift tax on the donor for gifts exceeding an annual exclusion amount. California does not levy its own state-level gift tax, mirroring the federal approach where the tax burden falls on the giver. Similarly, inheritances are not taxed as income to the beneficiary in California. While large estates may be subject to a federal estate tax, California does not impose a state-level estate or inheritance tax.

Life insurance proceeds paid to a beneficiary due to the death of the insured are generally exempt from both federal and California income tax. This exemption applies whether the proceeds are received as a lump sum or through an accidental death rider. However, any interest earned on proceeds held by the insurer before distribution may be taxable.

Certain welfare and public assistance benefits are also typically not considered taxable income. Programs like CalWORKs and General Assistance, which provide financial aid to eligible low-income families and individuals, are generally exempt from income tax. This also includes benefits such as the state and federal Earned Income Tax Credit (EITC), which do not count as income when calculating eligibility for public assistance programs.

Qualified scholarships and fellowships can be tax-free if they are used for eligible educational expenses. These expenses include tuition, fees, books, supplies, and equipment required for enrollment or courses. However, amounts used for room and board, travel, or other living expenses are typically considered taxable income. The recipient must be a degree candidate for the scholarship or fellowship to be considered qualified and thus potentially exempt.

Reimbursements for medical expenses are generally not taxable if they cover actual medical costs. This includes reimbursements from health insurance plans or employer-sponsored medical reimbursement accounts. However, if a taxpayer previously deducted medical expenses and later receives a reimbursement for those same expenses, the reimbursement may become taxable up to the amount of the prior deduction.

Child support payments are not considered taxable income for the recipient in California, nor are they tax-deductible for the payer. This rule applies uniformly at both the federal and state levels.

Workers’ compensation benefits received for occupational injuries or illnesses are generally exempt from both federal and California income tax. This exemption applies to payments for medical expenses, temporary disability, permanent disability, and death benefits.

Damages received for physical injury or sickness are typically excluded from taxable income. This includes compensation for medical bills, pain and suffering directly related to a physical injury, and lost wages resulting from the physical injury. However, punitive damages, interest on the settlement, or compensation for emotional distress not directly linked to a physical injury are generally taxable.

Income Exempt Only from California Tax

California’s tax code includes specific exemptions for certain income types that are subject to federal income tax. These distinctions are crucial for California residents to understand, as they can significantly impact their state tax liability.

Social Security benefits, while potentially partially taxable at the federal level depending on a taxpayer’s combined income, are fully exempt from California state income tax. This means that California residents do not include any portion of their Social Security benefits when calculating their state taxable income. This is a notable difference from federal law, where up to 85% of Social Security benefits can be subject to federal income tax.

Railroad Retirement Benefits are another category of income that receives special tax treatment in California. Tier 1 and Tier 2 benefits, which are components of the Railroad Retirement system, are entirely exempt from California state income tax. This aligns with the state’s policy of not taxing certain retirement benefits, distinguishing it from federal taxation which may apply to these benefits.

Winnings from the California State Lottery are fully exempt from California income tax. This exemption applies to all prizes won through official California Lottery games, regardless of the amount. While these winnings are subject to federal income tax, they are not considered taxable income for state purposes.

Interest earned on U.S. government obligations, such as U.S. Treasury bonds, notes, and bills, is exempt from California state income tax. While this interest is generally subject to federal income tax, California residents do not pay state income tax on these earnings.

Interest from certain municipal bonds is also exempt from California income tax. Specifically, interest earned on bonds issued by the State of California and its local governments is exempt from state income tax. However, interest from municipal bonds issued by other states or their local governments may be subject to California income tax, although it might be federally tax-exempt.

Conditional Exemptions

Some income sources are generally taxable but become exempt from California income tax under specific conditions or for particular groups of people. The precise criteria for these exemptions must be met for the income to be considered non-taxable.

Military pay can be exempt from California income tax under certain conditions. For instance, combat zone pay is generally excluded from federal and state income. Additionally, military members who are not legal residents of California but are stationed in the state may not be subject to California income tax on their military earnings. Specific allowances, such as housing and subsistence, can also be exempt from taxation.

The income of Native Americans can be exempt from California taxation if specific criteria are met. Income derived from sources within Indian country by enrolled members of federally recognized tribes who live in Indian country is typically not subject to state income tax. The source of the income and the residency of the tribal member within Indian country are key determinants for this exemption.

Certain disaster relief payments may also be exempt from income tax. Payments received for personal injury, sickness, or property damage resulting from a federally declared disaster area are often excluded from taxable income. The nature of the payment and its direct relation to the declared disaster are critical for this tax-free status.

Foster care payments received from a state or local government, or a qualified foster care placement agency, for providing foster care are generally not taxable. These payments are considered reimbursements for the expenses of caring for a foster child. The payments must be for the care of a qualified foster individual in the foster care provider’s home.

Specific education benefits, such as those provided under the Post-9/11 GI Bill, are generally exempt from income tax. These benefits cover tuition, fees, housing, and other educational expenses for eligible veterans and their dependents. Other veteran education benefits may also qualify for tax-exempt status, depending on their purpose and specific federal and state regulations.