What Types of Income Are Tax-Exempt for Individuals?
Common tax-exempt income includes qualified Roth IRA and Roth 401(k) distributions, interest from state and municipal bonds (generally exempt from federal income tax), certain employer-provided benefits like group term life insurance up to $50,000, workers' compensation payments, and inheritances (though the estate may owe estate tax). Veterans' disability benefits and some Social Security benefits also may be exempt.
What Makes a Nonprofit Organization Tax-Exempt?
Organizations qualify for federal tax-exempt status under Section 501(c)(3) if they operate exclusively for charitable, religious, educational, or scientific purposes, and distribute no profits to private shareholders. The IRS must approve the designation. Donors to 501(c)(3) organizations can deduct contributions on their returns, which is why this status matters to both nonprofits and their donors.
How Does Tax-Exempt Differ From Tax-Deferred?
Tax-exempt income is never taxed. Tax-deferred income is not taxed now but will be taxed later — for example, traditional IRA growth is tax-deferred until withdrawal. Municipal bond interest is tax-exempt; traditional 401(k) growth is tax-deferred. Roth accounts provide the rare combination of tax-deferred contributions and tax-exempt qualified withdrawals.
Frequently asked questions
Are municipal bonds always tax-exempt?
Municipal bond interest is generally exempt from federal income tax and often exempt from state and local taxes for residents of the issuing state. However, capital gains from selling muni bonds at a profit are taxable, and the Alternative Minimum Tax may apply to interest from certain private-activity bonds.
Is Social Security income tax-exempt?
Not always. Up to 85% of Social Security benefits become taxable if your combined income (AGI plus nontaxable interest plus half of Social Security) exceeds $34,000 for singles or $44,000 for joint filers. Lower-income recipients may owe tax on 50% of benefits or nothing at all.