EHTC writes: There are still ways to earn income
that is free from federal income tax. With the various tax increases
that have taken effect in recent years, tax-free income opportunities
are more valuable than ever.
Here are 10 sources of non-taxable income.
1. Gifts and Inheritances
If you receive a gift or
inheritance, the amount is generally not taxable. However, if you are
given or inherit property that later produces income such as interest,
dividends or rent, the income is taxable to you. (There may be gift tax
implications for the individual who gives a gift.)
2. Tax-Free Home Sale Gains
In one of the best tax-saving deals, an
unmarried seller of a principal residence can exclude (pay no federal
income tax on) up to $250,000 of gain, and a married joint-filing couple
can exclude up to $500,000 of gain. There are some limitations. You
must pass the following four tests to qualify.
-
Ownership Test - You must have owned the property for at least two years during the five-year period ending on the sale date.
-
Use Test -
You must have used the property as a principal residence for at least
two years during the same five-year period (periods of ownership and use
need not overlap).
-
Joint-Filer Test -
To be eligible for the maximum $500,000 joint-filer exclusion, at least
one spouse must pass the ownership test, and both spouses must pass the
use test.
-
Previous Sale Test -
If you excluded gain from an earlier principal residence sale, you
generally must wait at least two years before taking advantage of the
gain exclusion deal again. If you are a married joint filer, the
$500,000 exclusion is only available if neither you nor your spouse
claimed the exclusion privilege for an earlier sale within two years of
the later sale.
3. Life Insurance Proceeds
Proceeds from a life insurance policy
paid to you because of an insured person's death are generally not
taxable. (This includes proceeds paid under an accident or health
insurance policy or an endowment contract.) However, if you redeem a
policy on your own life for cash, any amount that is more than the cost
of the policy is taxable. In addition, interest income received as a
result of life insurance proceeds may be taxable.
4. Income from Tax-Free Roth IRAs
Roth IRAs are still a great tax-saving deal and can provide tax-free income. Roth accounts have two big tax advantages.
The first Roth advantage is tax-free withdrawals. Unlike
traditional IRA withdrawals, qualified Roth IRA withdrawals are free
from federal income tax (and usually state income tax). What is a
qualified withdrawal? In general it is one that is taken after the Roth
account owner has met both of the following requirements:
-
He or she has had at least one Roth IRA open for over five years.
-
He or she has reached age 59 1/2, is disabled or is dead.
The second Roth advantage is an exemption from the required minimum distribution rules. Unlike
with a traditional IRA, the original owner of a Roth account (the
person for whom the account is originally set up) is not burdened with
the obligation to start taking required minimum distributions (RMDs)
after age 70 1/2 or face a 50 percent penalty. Therefore, you can leave a
Roth account untouched for as long you live. This important privilege
makes the Roth IRA a great asset to leave to your heirs (to the extent
you don't need the Roth IRA money to help cover your own retirement-age
living expenses).
5. Tax-Free Section 529 Accounts
The biggest advantage of 529 college
savings plan accounts is they are allowed to accumulate earnings free of
any federal income taxes. When the account beneficiary (typically a
child or grandchild) reaches college age, federal-income-tax-free
withdrawals can be taken to cover his or her qualified higher education
expenses. State income tax breaks are often available too.
Helpfully enough, contributions to a
529 account will also reduce your taxable estate because they are
treated as gifts to the account beneficiary. Contributions in are
eligible for the $14,000 annual federal gift-tax exclusion.
Contributions up to the exclusion amount won't diminish your unified
federal gift and estate tax exemption ($5.43 million in 2015).
If you're feeling really generous, you
can make a larger lump-sum contribution to a 529 account and elect to
spread it over five years for gift-tax purposes. This allows you to
immediately benefit from five years' worth of annual gift-tax exclusions
while jump-starting the beneficiary's college fund. You make the
five-year spread election by filing the IRS gift-tax return form.
Example: You are
unmarried and can make a 2015 lump-sum contribution of up to $70,000 (5
times $14,000) to a Section 529 account set up for a child, grandchild
or other person you want to help. If you're married, you and your spouse
can together contribute up to $140,000 (2 times $70,000). Lump-sum
contributions up to these amounts won't diminish your unified federal
gift and estate tax exemption as long as you choose to take advantage of
the five-year spread privilege. If you want to help several children or
grandchildren, you can run the same 529 account drill for each one.
If you want (or need) to get your money
back from a 529 account, it is allowed under the tax rules. You can
take back all or part of the account balance. You'll owe taxes on any
withdrawn earnings plus a penalty equal to 10 percent of the withdrawn
earnings. However, that's a relatively small price to pay for the right
to reverse a decision, if desired.
6. Tax-Free Coverdell Education Savings Accounts
If you're not such a high roller when
it comes to tax-free college savings opportunities, you also have the
option of contributing up to $2,000 annually to a Coverdell Education
Savings Account (CESA) set up for a beneficiary (typically a child or
grandchild) who has not yet reached age 18. A CESA is an account set up
by a "responsible person," which means you, to function exclusively as
an education savings vehicle for the account beneficiary (typically a
child or grandchild).
CESA earnings are allowed to accumulate
federal-income-tax-free. Then, tax-free withdrawals can be taken to pay
for the beneficiary's college tuition, fees, books, supplies, and room
and board. If you have several beneficiaries in mind, you can contribute
up to $2,000 annually to separate CESAs set up for each one.
Here's the catch: The right to make CESA contributions is phased out if your modified adjusted gross income (MAGI) reaches certain levels.
However, this restriction can often be
circumvented by enlisting someone who is unaffected by the income
limitation. For example, you can give the contribution dollars to a
trustworthy adult who can then open up the CESA as the "responsible
person" and make a contribution on behalf of your intended beneficiary.
Keep in mind that when the "responsible person" is someone other than
yourself, your control over the account is lost.
7. Cash Rebates for Items Purchased
A cash rebate received from a dealer or
manufacturer for an item you buy is not income. However, you have to
reduce your tax basis by the amount of the rebate. For example, you buy a
new car for $28,000 and the manufacturer sends you a $2,000 rebate
check. Although the $2,000 is not income to you, your basis in the car
is now $26,000. That basis is used to calculate gain or loss when you
sell the car or depreciation if you use the vehicle for business
purposes.
8. Tax-Free Capital Gains and Dividends
Thanks to current tax law legislation,
the federal income tax rate on long-term capital gains and qualified
dividends is still 0 percent when they fall within the 10 or 15 percent
regular income tax rate brackets. The surprising truth is you can earn a
pretty healthy income and still be within the 15 percent bracket and
thus qualify for the 0 percent rate on some or all of your long-term
capital gains and dividends.
Key Point: Adjusted gross income is calculated after subtracting
any write-offs allowed on page 1 of Form 1040 (so-called above-the-line
deductions). These write-offs include deductible IRA and self-employed
retirement account contributions, health savings account contributions,
self-employed health insurance premiums, alimony payments, moving
expenses and others. So, if you have some above-the-line deductions for
2014, your AGI can be that much higher, and you will still be in the 15
percent rate bracket.
9. Qualified Scholarships
Payments received from a qualified
scholarship are normally not taxable. Amounts you use for certain costs,
such as tuition and required course books, are not taxable. However,
amounts required to be used for room and board are taxable.
10. Certain Court Awards and Damages
Compensatory damages for personal
physical injury or physical sickness (received in a lump sum or
installments) are free from federal tax. However, punitive damages are
taxable. Awards for unlawful discrimination or harassment are also
taxable. If you receive a court award or out-of-court settlement,
consult with your tax adviser about the tax implications.
Conclusion
While most sources of income are
taxable, you might be fortunate enough to receive income that brings you
no federal tax headaches. Consult with your tax adviser for more
information in your situation.