What Is Exempt Income?

Exempt income refers to certain types of income not subject to income tax. Some types of income are exempt from federal or state income tax or both. The IRS determines which types of income are exempt from federal income tax and the circumstances for each exemption. States have their own rules that define what counts as exempt income.

Understanding Exempt Income

Some income and benefits are nontaxable under certain circumstances. Several health-related benefits are tax-exempt, including benefits from employer-sponsored supplemental disability insurance purchased with after-tax dollars, private insurance plans funded with after-tax dollars, most benefits from employer-sponsored health insurance plans, and worker's compensation.

Gifts that exceed a certain value can trigger a gift tax on the person providing the gift. However, any gift worth less than $17,000 in 2023 and $18,000 in 2024 is exempt from income tax. Regardless of value, gifts, including medical expenses paid for someone else and charitable donations, are income tax exempt. Charitable contributions are also tax-deductible. 

The Tax Cuts and Jobs Act (TCJA) in 2017 eliminated personal exemptions from tax years 2018 to 2026 but roughly doubled the standard deduction. For tax years 2023 and 2024, the standard deductions are:

Examples of Exempt Income

Distributions from health savings accounts (HSAs) are only exempt from income tax if they are used for qualified medical expenses. Qualified distributions from Roth 401(k) plans and Roth IRAs funded with after-tax dollars are tax-exempt. 

Other investments may also be protected from income tax. For example, interest earned from municipal bonds is exempt from federal and state income tax if you reside in the state where the bond was issued. Capital losses from sold investments can also reduce your taxable income by up to $3,000 annually.

If someone dies and you are the beneficiary of a life insurance benefit, that is also nontaxable income but may be subject to estate tax. The estate tax, or death tax, applies to a portion of an estate after it exceeds a certain threshold, $12.92 million in 2023 and $13.61 million in 2024.

The Bottom Line

Almost all forms of income are taxable including wages, salaries, tips, and other types of income from an employer or as a freelancer. But certain forms of income aren't taxable. Exempt income includes things like distributions from some retirement accounts, gifts under a certain amount, certain benefits, and private insurance plans.