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What is Tax-Exempt Income?

By Felicia Dye
Updated: Jan 28, 2024

In the United States, most money that is received by a person is subject to federal and state income tax. There are, however, some types of income that a person is allowed to receive without having to share any portion of it with the government. This is known as tax-exempt income.

At the end of a tax year, most of the money earned by individuals or business entities typically should be calculated and disclosed on the relevant tax forms. Based on a series of subsequent calculations, the amount of tax that is owned is calculated. This is known as income tax.

Some income is exempt from federal taxes without exception. Examples of these include welfare benefits, federal tax returns, and veteran benefits. The federal government does not under any circumstances attempt to claim ownership to any part of these funds.

A person usually should be careful when deciding whether certain other items are tax-exempt income or not. There are some categories where this determination is dependent upon the circumstances. These categories include scholarships, inheritances, and interest income. Individuals and business entities are responsible for being aware of the rules regulating these categories.

It also is important to note that some tax-exempt income must still be reported. This is the case, for example, with interest income. There is a space on the appropriate tax form for disclosing tax-exempt interest income.

Everyone does not pay the same tax rates. The amount of income that is received helps to determine into which tax bracket individuals and business entities fall. If a person is in one tax bracket, tax-exempt income, even when disclosed, should not push her into another tax bracket.

The tax-exempt categories set forth by states can be different than those set forth by the federal government. Some states do not charge personal income taxes. Other states exempt items that the federal government does not, such as pensions. In some instances, income that is exempt from federal tax obligation is not exempt from state tax obligation. An example is the money received from a federal income tax return.

Tax-exempt income is an issue that can carry consequences if it is not properly handled. When a person believes that she has income that is tax-exempt, it is wise to get advice from tax preparation professionals or to completely pass the responsibility of calculating income tax to them. This especially is true when a person believes that she has several categories of tax-exempt income.

WiseGeek is dedicated to providing accurate and trustworthy information. We carefully select reputable sources and employ a rigorous fact-checking process to maintain the highest standards. To learn more about our commitment to accuracy, read our editorial process.
Discussion Comments
By anon318170 — On Feb 06, 2013

I received $17K in social security last year. When I entered this into Turbotax, nearly $7K was noted as immediately taxable. I had not entered anything else. I was told I owed IRS nearly $300! Why is that $7K considered taxable?

By anon261884 — On Apr 17, 2012

My husband worked with a man who said he was tax exempt, and the company did not take taxes out on him, true my husband was part of management. This man would only work so many hours a week because of this and not losing his families food stamps. How is it possible that some people don't pay, and at what income can they just write exempt on their work IRS form?

By Sunny27 — On Aug 27, 2010

Sneakers41- Although savings accounts are taxable in the United States, there is a tax free savings account option in Canada.

It is called the TFSA which stands for tax free savings account. You can contribute up to $5,000 a year and there are no withdrawal penalties.

In addition, Canadian’s can also qualify for governmental programs as this asset is not factored into a family’s income level.

By sneakers41 — On Aug 27, 2010

Another form of tax free income is government funded aid, like welfare, or student loans.

In addition, disability income is also considered tax-free income. Food Stamps are also tax free, and some people who earn below a certain amount do not pay taxes on their regular incomes.

Students are perfect examples as their income is also quite low. When they file a tax return, they usually list their income as exempt.

By GreenWeaver — On Aug 27, 2010

There are some tax exempt income opportunities. For example, tax free bond funds and tax exempt municipal bonds offer earnings that are tax exempt.

Municipal bonds offer an annual yield that pays tax-free interest payments twice a year for the term of the bond.

The federal government offers the tax free status so that people will invest in their state or cities.

To invest in these funds, most funds require an initial investment of $10,000 to $25,000. Many people look to tax free municipal bonds for passive retirement income.

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