Tax exempt income is income that you are not obligated to pay income taxes on. In the United States (US), this status can involve federal income tax, state income tax or both, depending on the instrument that warrants this exemption. In addition to individuals having tax exempt income, organizations, societies and clubs can also hold a non-profit status and be exempt from paying income tax on their income sources.
For personal income tax, the most common source of tax-free income is the interest paid on municipal and treasury bonds. Municipal bonds come in the form of general obligation bonds, revenue bonds and certificates of participation bonds. They can be purchased as specific bonds on an individual basis, or can be purchased as a composite of bonds, packaged into mutual funds or index funds.
The interest is normally paid semi-annually or in the case of zero coupon bonds, at maturity. These bonds are exempt from state and federal taxes as long as the holder of the bond is reporting his/her personal income tax from the same state. Out of state municipal bonds are taxable to your state of residency, but remain federally tax exempt.
Until the 1980’s, municipal bonds were also issued in the form of bearer bonds, which did not have to be registered. They were held privately and interest coupons were clipped and submitted to any bank for payment with no paper trail required. When the bonds matured, the bonds themselves would be submitted for redemption at any bank or savings and loan. These bonds could not be monitored and fell into the hands of money laundering and other illegal instruments and were consequently phased out of usage.
The interest on treasury bills and bonds is tax exempt income for state and local taxes. The federal tax portion of this interest income is only reportable at maturity or when the bonds are redeemed. The government offers these fixed income products as tax incentives to promote and generate state and federal improvements. They also are used to maintain quality services and benefits for the public.
Benefits from disability, social security, welfare, veterans and workers compensation are considered tax exempt income. They are only taxable to people earning a total income exceeding a specific amount during a calendar year. Most gifts and inheritance are also considered tax exempt income. Fellowships and scholarships usually fall into this category as well but need to be investigated, as some are taxable.
A tax exemption status is given to non-profit organizations. These vary in nature, such as charitable, labor and veteran’s organizations, churches, schools, business and amateur sports leagues, farm associations, armed forces and some social clubs. Most fraternal, literary and scientific societies are also considered not-for-profit.
In order for any non-profit organization to maintain their tax exempt status, they must follow strict guidelines and file an Internal Revenue Service (IRS) Form 990. This full disclosure report has been required since 2008. This form insures financial accountability to the IRS and the public. The only exemptions to this report are faith-based organizations, state institutions and government corporations.