Exempt Income

Exempt income is any category of earnings that federal, state, or local tax law specifically excludes from taxable income. You receive it, but you do not owe tax on it. Common examples include interest on municipal bonds, workers' compensation payments, employer-paid health insurance premiums, and certain military allowances. The exemption is always statutory: the specific law must say it is excluded, or it is not.

Exempt income is not the same as deducted income. A deduction reduces your taxable income after you receive it. Exempt income never enters the tax calculation at all.

Major Categories of Federal Exempt Income

The IRS enumerates exempt income categories in the Internal Revenue Code, and the list is broader than most people realize.

• Municipal bond interest: Interest earned on bonds issued by U.S. states, cities, and local governments is exempt from federal income tax under Section 103. If you buy a bond issued by your own state, the interest is often also exempt from your state's income tax.
• Life insurance death benefits: Proceeds paid to beneficiaries of a life insurance policy upon the insured's death are excluded from gross income under Section 101.
• Gifts and inheritances: Property received as a gift or inheritance is not included in the recipient's income. The estate or donor may owe gift or estate tax, but the recipient owes no income tax on receipt.
• Workers' compensation: Payments received as workers' compensation for occupational injuries or illness are fully excluded from federal income tax.
• Employer-sponsored health insurance: Premiums your employer pays for your health insurance, and employer contributions to Health Savings Accounts, are excluded from your taxable wages.
• Scholarship amounts used for tuition and fees: Scholarships applied to qualified education expenses, such as tuition and required fees, are excluded from income under Section 117. Amounts used for room and board are taxable.

How Exempt Income Affects Your Tax Strategy

Municipal bond interest is the most strategically significant form of exempt income for high-income investors. The after-tax yield advantage of a municipal bond over a taxable bond increases with your marginal tax bracket. A municipal bond yielding 3.5% delivers a taxable-equivalent yield of 5.83% for a taxpayer in the 40% combined federal and state bracket. At a 25% combined bracket, the same municipal bond's taxable equivalent is only 4.67%.

This is why wealthy investors hold municipal bonds and lower-income investors typically do not. The exemption is most valuable where the avoided tax is highest.

State-Level Exempt Income Varies Significantly

Each state defines its own exempt income categories, which may diverge significantly from federal rules. Social Security benefits are federally taxable above certain income thresholds but fully exempt in many states including California, Florida, and New York. Some states exempt retirement plan distributions up to a dollar limit. Others tax interest on out-of-state municipal bonds while exempting their own.

When planning around exempt income, always verify both federal and state treatment separately. Federal exemption does not guarantee state exemption, and vice versa.

Sources

• https://www.irs.gov/publications/p525
• https://www.irs.gov/taxtopics/tc553
• https://www.irs.gov/taxtopics/tc403