You may think you have to pay tax on all income you receive but it’s not true. There are still ways to earn income that is free from federal income tax. With the various tax increases that took effect at the beginning of this year, tax-free income opportunities are more valuable than ever.
Here are 10 sources of non-taxable income:
1. Gifts and Inheritances
If you receive a gift or inheritance, the amount is generally not taxable. However, if you receive (or inherit) property that later produces income — such as interest, dividends, or rent — the income is taxable to you. There may be tax implications for the individual who gives a gift.
2. Tax-Free Home Sale Gains
In one of the best tax-saving deals, an unmarried seller of a principal residence can exclude (pay no federal income tax on) up to $250,000 of gain, and a married joint-filing couple can exclude up to $500,000 of gain. There are some limitations. You must pass the following four tests to qualify.
• Ownership Test – You must have owned the property for at least two years during the five-year period ending on the sale date.
• Use Test – You must have used the property as a principal residence for at least two years during the same five-year period (periods of ownership and use need not overlap).
• Joint-Filer Test – To be eligible for the maximum $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test.
• Previous Sale Test – If you excluded gain from an earlier principal residence sale, you generally must wait at least two years before taking advantage of the gain exclusion deal again. If you are a married joint filer, the $500,000 exclusion is only available if neither you nor your spouse claimed the exclusion privilege for an earlier sale within two years of the later sale.
If you don’t qualify for the maximum $250,000 or $500,000 gain exclusion due to failure to pass all the preceding tests, you may still qualify for a prorated (reduced) exclusion amount if you had to sell your home for job-related or health reasons or for certain other IRS-approved reasons
3. Life Insurance Proceeds
Proceeds from a life insurance policy paid to you because of an insured person’s death are generally not taxable. (This includes proceeds paid under an accident or health insurance policy or an endowment contract.) However, if you redeem a life insurance policy for cash, any amount that is more than the cost of the policy is taxable. In addition, interest income received as a result of life insurance proceeds may be taxable.
4. Income from Tax-Free Roth IRAs
Roth IRAs are still a great tax-saving deal and can provide tax-free income. Roth accounts have two big tax advantages.
The first Roth advantage is tax-free withdrawals. Unlike traditional IRA withdrawals, qualified Roth IRA withdrawals are free from federal income tax (and usually state income tax). What is a qualified withdrawal? In general, it is one that is taken after the Roth account owner has met both of the following requirements:
• He or she has had at least one Roth IRA open for over five years.
• He or she has reached age 59 1/2, is disabled, or is dead.
The second Roth advantage is an exemption from required minimum distribution rules. Unlike with a traditional IRA, the original owner of a Roth account (the person for whom the account is originally set up) is not burdened with the obligation to start taking required minimum distributions (RMDs) after age 70 1/2 or face a 50 percent penalty. Therefore, you can leave a Roth account untouched for as long you live. This important privilege makes the Roth IRA a great asset to leave to your heirs (to the extent you don’t need the Roth IRA money to help cover your own retirement-age living expenses).
5. Tax-Free Section 529 Accounts
The biggest advantage of 529 college savings plan accounts is they are allowed to accumulate earnings free of any federal income taxes. When the account beneficiary (typically a child or grandchild) reaches college age, federal-income-tax-free withdrawals can be taken to cover his or her higher education expenses. State income tax breaks are often available, too.
Helpfully enough, contributions to a 529 account will also reduce your taxable estate because they are treated as gifts to the account beneficiary. Contributions in 2013 are eligible for the $14,000 annual federal gift tax exclusion. Contributions up to the exclusion amount won’t diminish your unified federal gift and estate tax exemption ($5.25 million for 2013).
If you’re feeling really generous, you can make a larger lump-sum contribution to a 529 account and elect to spread it over five years for gift tax purposes. This allows you to immediately benefit from five years’ worth of annual gift tax exclusions while jump starting the beneficiary’s college fund. You make the five-year spread election by filing the IRS gift tax return form.
Example: You are unmarried and can make a 2013 lump-sum contribution of up to $70,000 (five times $14,000) to a Section 529 account set up for a child, grandchild, or other person you want to help. If you’re married, you and your spouse can together contribute up to $140,000 (two times $70,000). Lump-sum contributions up to these amounts won’t diminish your unified federal gift and estate tax exemption as long as you choose to take advantage of the five-year spread privilege. If you want to help several children or grandchildren, you can run the same 529 account drill for each one.
If you want (or need) to get your money back from a 529 account, it is allowed under the tax rules. You can take back all or part of the account balance. You’ll owe taxes on any withdrawn earnings plus a penalty equal to 10 percent of the withdrawn earnings. However, that’s a relatively small price to pay for the right to reverse a decision, if desired.
6. Tax-Free Coverdell Education Savings Accounts
If you’re not such a high roller when it comes to tax-free college savings opportunities, you can contribute up to $2,000 annually to a Coverdell Education Savings Account (CESA) set up for a beneficiary (typically a child or grandchild) who has not yet reached age 18. A CESA is an account set up by a “responsible person,” which means you, to function exclusively as an education savings vehicle for the account beneficiary (typically a child or grandchild).
CESA earnings are allowed to accumulate federal-income-tax-free. Then, tax-free withdrawals can be taken to pay for the beneficiary’s college tuition, fees, books, supplies, and room and board. If you have several beneficiaries in mind, you can contribute up to $2,000 annually to separate CESAs set up for each one.
Here’s the catch: Your right to make CESA contributions is phased out between modified adjusted gross income (MAGI) of $95,000 and $110,000 or between $190,000 and $220,000 if you’re a married, joint filer.
However, this restriction can often be circumvented by enlisting someone who is unaffected. For example, you can give the contribution dollars to a trustworthy adult who can open up the CESA as the “responsible person” and make a contribution on behalf of your intended beneficiary. Keep in mind that when the “responsible person” is someone else, you lose control over the account.
7. Cash Rebates for Items Purchased
A cash rebate received from a dealer or manufacturer for an item you buy is not income. However, you have to reduce your basis by the amount of the rebate. For example, you buy a new car for $28,000 and the manufacturer sends you a $2,000 rebate check. Although the $2,000 is not income to you, your basis in the car is now $26,000. That basis is used to calculate gain or loss when you sell the car or depreciation if you use the vehicle for business purposes.
8. Tax-Free Capital Gains and Dividends
Thanks to the Fiscal Cliff Law, the federal income tax rate on long-term capital gains and qualified dividends is still 0 percent when they fall within the 10 or 15 percent regular income tax rate brackets. The surprising truth is you can earn a pretty healthy income and still be within the 15 percent bracket and, thus, qualify for the 0 percent rate on some or all of your long-term capital gains and dividends.
Example for a married taxpayer: You are a joint filer with two dependent children who claims the standard deduction. For 2013, you could have up to $100,300 of adjusted gross income — including long-term capital gains and dividends — and still be within the 15 percent rate bracket. Your taxable income would be $72,500, which is the top of the 15 percent bracket for joint filers in 2013.
Example for a head of household taxpayer: You are divorced and file as a head of household. You have two dependent children and claim the standard deduction. For 2013, you could have up to $69,250 of adjusted gross income — including long-term capital gains and dividends — and still be within the 15 percent rate bracket. Your taxable income would be $48,600, which is the top of the 15 percent bracket for heads of households in 2013.
Example for a single taxpayer: You are unmarried with no kids and claim the standard deduction. For 2013, you could have up to $46,250 of adjusted gross income — including long-term capital gains and dividends — and still be within the 15 percent rate bracket. Your taxable income would be $36,250, which is the top of the 15 percent bracket for singles in 2013.
If you itemize deductions, your 2013 adjusted gross income — including long-term capital gains and dividends — could be even higher, and your taxable income would still be in the 15 percent bracket.
Key Point: The adjusted gross income figures cited above are after subtracting any write-offs allowed on page 1 of Form 1040 (so-called above-the-line deductions). These write-offs include deductible IRA and self-employed retirement account contributions, health savings account contributions, self-employed health insurance premiums, alimony payments, moving expenses, and others. So, if you have some above-the-line deductions for 2013, your AGI can be that much higher than the numbers cited above, and you will still be in the 15 percent rate bracket. And if you itemize instead of claiming the standard deduction, your AGI can be higher still.
9. Qualified Scholarships
Payments received from a qualified scholarship are normally not taxable. Amounts you use for certain costs, such as tuition and required course books, are not taxable. However, amounts required to be used for room and board are taxable.
10. Certain Court Awards and Damages
Compensatory damages for personal physical injury or physical sickness (received in a lump sum or installments) are free from federal tax. However, punitive damages are taxable. Awards for unlawful discrimination or harassment are also taxable. If you receive a court award or out-of-court settlement, consult with your tax adviser about the tax implications.
Conclusion: While most sources of income are taxable, you might be fortunate enough to receive income that brings you no federal tax headaches. Consult with your tax adviser for more information in your situation.
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– content reprinted with permission from BKR International.
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