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Nontaxable vs. Taxable Income: What's the Difference

Sep 28, 2022 By Triston Martin

Most types of earned income, as well as anything else obtained in return for monetary value, services, or tangible property, might be considered taxable. Included in taxable income are:

  • Wages, wages, tips, as well as revenue from self-employment
  • Pay incentives for workers such as bonuses, prizes, and commissions
  • Unemployment compensation
  • Rental income
  • Capital gains, interest, dividends, and stock options are all forms of compensation.

The year in which taxable income was received, which ended on December 31, is the tax year for that income. Your W-2 form will most likely have a section for reporting taxable income received from your employer. However, revenue may be reported differently by temporary workers and business partners depending on the circumstances. On the other hand, income not subject to taxation is referred to as tax-free money. Your salary or compensation from your work or place of employment does not often count against your nontaxable income. Common income exempt from taxation includes those received due to worker's compensation, inheritances, alimony, life insurance, death benefits, and child support.

Nontaxable Income

According to the Internal Revenue Service (IRS), some income categories are not subject to taxation. Earnings from employment are often excluded from the definition of nontaxable income. In its place, it comprises various sources that are not connected to salaries and particular investment profits.

For instance, public assistance programs that grant income to the financially poor are often exempt from taxes. One such program is SSI needs-based public assistance program. Additionally, payments received from public welfare funds, no-fault car insurance, disability insurance, or disability benefits for which your company paid the insurance premiums are not regarded as nontaxable income.

How Nontaxable Income Works

You have money that you obtained that is regarded tax-free if it is not nontaxable, which means that you do not have to pay taxes on it. Your earned income is often subject to taxation on the federal and state levels, depending on where you live. On the other hand, certain forms of income can be taxed differently by the federal government compared to the state government.

Because of this, it is essential to review the tax code of your home state since the regulations governing taxes in each state might differ. Wages are subject to taxation in several states, whereas others are not. For instance, while New Hampshire does not impose a tax on individual income, the state levies a 5% tax on investment income such as interest and dividends. However, citizens of New Hampshire are still obligated to pay income tax to the federal government.

The interest received on municipal bonds is one investment that does not result in taxable income for the investor. Withdrawals from traditional retirement funds are subject to income taxation, whereas withdrawals from Roth retirement accounts are tax-free.

Taxable Income

A person's taxable income is the amount of their income that may be subject to taxation. During tax season, a person is required to provide a disclosure of this sum on their tax return. For the federal income tax, taxable income includes, for instance, all of the following categories of income:

  • Dividends
  • Gambling winnings
  • The bulk of interest income
  • Income received in this manner
  • Rental income

It is important to remember that just because you earned taxable income during the year does not automatically indicate that you are required to pay taxes on that income. This is because, when computing your tax obligation on your tax return, such as Form 1040 for federal income tax, you are authorized to deduct certain appropriate adjustments and deductions from the amount of your taxable income. This is the reason why this is the case.

How Taxable Income Works

When considering a taxpayer's liability for federal income tax, the whole amount of income received by that taxpayer is presumed to be taxable unless the Internal Revenue Code provides a particular exemption for that kind of income. Therefore, all money earned by citizens and residents of the United Indicates is considered taxable unless the Internal Revenue Code states that a certain piece of income is taxable from taxation.

For instance, although unemployment compensation is typically regarded as taxable income for the federal income tax, the income from unemployment compensation may be disregarded by some states, such as California, for that state's income tax. On the other hand, whereas interest income from municipal bonds is often exempt from taxation for purposes of the federal income tax, for purposes of the California income tax, this exemption only applies to the interest received on municipal bonds issued by California cities. Interest earned on municipal bonds not issued by a locality in California is subject to taxation in that state.

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