Taxable vs. Non-Taxable Income: What to Include on a Tax Return
Including or excluding the wrong income sources on your tax return can result in an overblown tax bill or penalties. Here’s how to avoid it.
March 2, 2022
Filing a tax return sounds simple enough — you just record your income and expenses then send it off. Yet when it’s time to put pen to paper (or keyboard and cursor to screen), you suddenly realize how complicated everything is. With the 2021 tax return deadline approaching, it’s time to get your head around the finer details. One of the most crucial aspects to understand is the difference between taxable vs. non-taxable income.
Let’s run through a detailed overview of taxable and tax-free income, along with other important details about how income tax returns work (including why it’s crucial to report your income correctly).
Taxable vs. non-taxable income
In the eyes of the government, the money we earn or receive falls into one of two categories: taxable or non-taxable income. You need to include taxable income on your tax return and pay taxes on it, but you will be exempt from owing taxes on non-taxable income. However, in some cases, the non-taxable income will need to be shown on your tax return.
It’s possible that your full-time wage isn’t your only source of taxable income. It’s not uncommon to have income from various sources. In addition to your full-time job, you may have a side hustle, regular gifts of money from a family member or retirement accounts — just to name a few.
The Internal Revenue Service (IRS) defines which types of income you need to pay tax on. But, as we’ll discuss later, keep in mind that some income sources may be taxable for one person and non-taxable for another based on their specific situation.
Common types of taxable income
First of all, the category nobody likes: income that is taxable. Here are the income sources that the IRS deems taxable:
Wages, including tips, fringe benefits (like company cars), bonuses, awards and sales commission
Self-employment, partnership and S corporation income
Social Security benefits (in some cases)
Rental income from real estate
Interest income from savings or checking accounts, including interest earned offshore
Investment income, including capital gains (which may be subject to capital gains tax), stock options and dividends
Withdrawals from a 401(k), 403(b) or traditional IRA
Winnings from gambling (includes lotteries and raffles and applies even if you win a prize rather than cash)
Virtual currencies (e.g., Bitcoin)
Royalties (includes copyrights and patents)
The fair market value of anything you earn as part of a bartering agreement (e.g., you received an iPhone worth $500 for developing a website)
Canceled, forgiven or discharged loans or debt
Lawsuit compensation (if being compensated for lost pay)
Some types of assistance, like unemployment compensation, severance pay, disability retirement payments from employer-paid plans or sickness and injury employer payments
Employer contributions to nonqualified retirement plans (usually only used for very high-earning employees)
While these are the most common sources of taxable income, everyone’s financial situation is slightly different. If you have questions about your circumstances, it’s best to speak with a tax professional.
We've covered so many income sources already, you might wonder what's left to be considered non-taxable income. You might be surprised at how many there are.
Common types of tax-free income
Although the list above sounds pretty big, there are also plenty of tax-exempt income sources. According to the IRS, some common non-taxable income sources are:
Social Security income, as long as your total income is below a certain threshold, and most healthcare benefits
Child support payments received
Alimony from a divorce (if the decree was finalized after 2018)
Gifts (but they’re subject to gift tax if you receive more than $15,000 per donor per year)
Roth IRA withdrawals (as long as you take qualified distributions).
Inheritance (but bear in mind this varies when it comes to state taxes — for instance, New York and Illinois have an estate tax on assets, and other states have inheritance taxes)
Employer health insurance, including flexible spending accounts, health reimbursement arrangements and health savings accounts (HSAs)
Workers’ compensation payments (for injuries or illnesses related to the workplace)
Disability insurance payments from no-fault car insurance, employer-paid disability benefits or payments from a public welfare fund (e.g., blindness payments)
Qualifying adoption reimbursements
Cash rebates (e.g., credit card cash back)
Municipal bond interest
Death benefits from a life insurance policy
Proceeds from a lawsuit (other than payments to compensate for lost pay)
Income that can be either taxable or tax-free
Your responsibility to pay taxes might be a certainty, but figuring out what you owe taxes on isn’t always so simple. As we mentioned, some types of income may be taxable in some cases but considered non-taxable income in others. Here are a few of those ambiguous areas.
In the case of scholarships, your tax status depends on what you use the money for. If you bought something that isn’t directly related to your education, you might have to pay tax on the scholarship money you used for it. For example, paying rent usually isn’t a required education expense, but textbooks and tuition fees are.
Similarly, proceeds from selling your home are usually tax-free, but the profit must remain below a certain threshold ($250,000 for one person or $500,000 for those filing a joint return), in addition to other requirements.
Another example is an employee achievement award. Whether it’s taxable depends on the type of reward you receive and its total value. For example, if you receive a tangible item as a reward, such as a personalized pen or plaque with a total value below $400, you won’t owe taxes. But if you receive a cash reward, it would be subject to tax.
Finally, you don’t have to pay tax on Social Security retirement income if it’s your only income source — but if you also receive enough money from other areas, it becomes taxable. If you earned more than $25,000 as an individual or more than $32,000 if you file a joint return, you may have to pay tax on up to 50% of your Social Security benefits. This rises to up to 85% if you earn more than $34,000 as an individual or $44,000 if you file a joint return.
What to consider before you file
Reading the lists above, you might have come across items that didn’t even occur to you. Maybe you’re doubting that everyone does as much due diligence as you and wondering if you could get away with excluding some of your income on your tax return. The short answer is no. A “substantial understatement of income tax” (understating your bill by $5,000 or by 10%, whichever is greater) could result in a penalty worth 20% of your tax underpayment — plus interest.
It’s simply not worth the risk.
This isn’t the only complication to consider. Taxpayers face not just federal income tax but, potentially, state income tax — and tax laws vary between states. Although most categories of income remain the same between states, this isn’t always true, as we’ve seen above in the case of inheritance and estate taxes.
Also, if you’re self-employed or a business owner (even if it’s just a side hustle), you might be able to get tax deductions from your gross income. This can take away some of the pain from realizing that certain income sources are taxable.
Know your taxable and non-taxable income sources
When it’s time for tax preparation, it’s important to know all of your income sources. This will help you ensure you're filing a complete tax return and paying enough in taxes. Keep in mind that some types of income that are non-taxable for someone else may be taxable for you depending on your income level and specific circumstances.
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