Taxable And Tax Free Sources Of Income


Most types of income are taxable. However, you might not have to pay tax on some types of income.

Taxable income

The most common types of taxable income are:

  • Wages, salaries, and tips — By law, your employer must send you a W-2 that shows how much you were paid in:
    • Salary
    • Tips — To learn more, see the Tip Income tax tip.
    • Commissions
    • Bonuses
    • Vacation pay
    • Sick pay
    • Severance pay, taxable in year paid
  • Extra cash – The IRS considers extra money you make for side jobs as self-employment income. Report this income on Schedule C. If you make more than $400 from your side job, you’ll need to file a Schedule SE and pay Social Security and Medicare taxes on the income.
  • Alimony received — If you get alimony as a result of a divorce decree or separation agreement, the payments you receive are fully taxable. If you paid alimony during the year, you can deduct it even if you don’t itemize deductions.
  • Unemployment benefits — Unemployment compensation benefits are fully taxable. To learn more, see the Unemployment Income tax tip.
  • Jury duty pay — Jury duty payments are taxable. However, you can deduct any part of the payment you give to your employer in exchange for continuing your salary.
  • Pension and annuity payments — Pension and annuity payments are taxed. However, a portion might be tax-free. Ex: After-tax contributions to an annuity are considered tax-free when withdrawn.
  • Awards — If you receive an award from your employer for your job performance, it’s usually taxable. The award’s fair market value (FMV) is included in your W-2 income. This can include an all-expenses-paid trip or some other type of goods or services.

    However, gifts of property you receive for your length of service or other achievement are tax-free (Ex: a gold watch). The tax-free amount is limited to your employer’s cost. Also, the gift’s value can’t be more than $1,600.

  • Barter — The FMV of property or services you receive or provide in exchange for work done is taxable income. Report this income on Schedule C. You can use another form or schedule if you barter property items instead of services.

    If you’re a member of a barter exchange, you should receive a Form 1099-B. This shows the FMV of all property and services you traded during the year.

  • Disability payments — If your employer pays the premiums for your disability insurance, disability payments you receive are usually fully taxable. However, if you pay the premiums, the payments you receive are tax-free. Veterans’ disability benefits and workers’ compensation are also tax-free.
  • Gambling winnings — Gambling winnings are fully taxable and include:
    • Lottery payouts
    • Sweepstakes payouts
    • Bingo winnings
    • Raffle winnings
    • Casino winnings

  • Prizes — All prizes are taxable. If you win a prize, you must include the FMV of the prize in your income.

Tax-free income

These are the most common types of tax-free income:

  • Auto rebates — A rebate is actually a reduction in price of the auto. It isn’t taxable income. However, a rebate reduces your basis in the auto.
  • Carpool receipts — If you drive a carpool to and from work, you don’t need to report payments you receive from passengers. These payments are considered reimbursement for your expenses, not income.
  • Child support payments — The payor can’t deduct child support, and payments are tax-free to the recipient. To learn more, see the Alimony and Child Support tax tip.
  • Casualty insurance proceeds — If you’re reimbursed for a loss, like a car accident or house fire, you usually don’t have to report the income on your return.

    However, you should include the payment when you figure any gain or loss from the casualty or theft. Some of these payments might be taxable.

  • Combat pay — Your pay is tax-free if you serve in a combat zone and you’re one of these members of the military:
    • Enlisted member
    • Warrant officer
    • Commissioned warrant officer

If you’re a commissioned officer who served in a combat zone or was hospitalized as a result of your service, the amount you can exclude is limited to the total of:

    • Highest rate of enlisted pay
    • Imminent-danger pay
    • Hostile-fire pay

This doesn’t apply to commissioned warrant officers.

To learn more, see Publication 3: Armed Forces’ Tax Guide at

  • Damages — Some types of compensation are usually tax-free. This includes compensation you received for:
    • Damages for a personal physical injury or sickness
    • Emotional distress suffered as a result of the personal physical injury or sickness

However, if you receive compensation for these types of damages, the income is taxable:

    • Lost wages or profits
    • Punitive damages

To learn more about other situations where the amount received might be taxable, see Publication 525 at

  • Dividends on a life insurance policy — Premiums are usually paid with after-tax dollars. So, dividends you receive are considered to be an overpayment of your premium. These are usually tax-free. If the dividends you receive is more than the premiums you paid, the excess amount is taxable.
  • Coverdell education savings accounts (ESAs) — Withdrawals from these accounts are tax-free if:
    • You use the money to pay for qualified education expenses (Ex: tuition, books, and fees).
    • The money is for the designated beneficiary enrolled at an eligible educational institution.

To learn more, see the Education Savings Accounts (ESAs) tax tip.

  • Gifts — If federal gift tax is owed on the gift, the giver owes the tax. So, you don’t usually need to report the receipt of gifts.
  • Health and accident insurance benefits — If you’re reimbursed for medical expenses you paid out of pocket, the money you receive isn’t taxable. You also don’t have to pay tax on compensation received for the:
    • Permanent loss of the use of part of the body
    • Permanent disfigurement
  • Health savings accounts (HSA) — Withdrawals from an HSA are tax-free if they’re used to pay qualifying medical expenses.
  • Inheritances — Any money or property you inherit is tax-free unless the item is considered to be income in respect of a decedent (IRD). Items like retirement accounts are usually considered to be IRD. If you inherit a traditional IRA or company retirement benefits, you must pay tax on the income just as the deceased would have had to do.

    For inheritances, your basis is usually the property’s FMV on the day the person who gave it to you died. You need to know the basis of the property. This is so you can figure the amount of capital gain or loss you’ll have when you dispose of the property.

    For property you inherited from someone who died in 2010, your basis will be the FMV on the date of death. This is true unless the executor of the estate made a special election. If so, your basis will be the deceased individual’s basis in the property.

    The Tax Relief Act of 2010 created a special election that estate executors could make to allow the use of either of these:

    • Modified-carryover-basis rules
    • FMV rules

Consult with the executor of the estate for individuals who died in 2010 for your basis.

  • Life insurance — Life-insurance proceeds you’re paid from the deceased’s policy aren’t taxable. However, if you receive the proceeds in installments over a number of years, the interest earned on that account is taxable income.

    If your spouse died before Oct. 23, 1986, and you’re receiving installment payments, you can exclude up to $1,000 a year in interest included in the installments. You can continue to claim the exclusion even if you remarry.

  • Municipal bond interest — If you receive interest on bonds issued by state and local governments, the interest is usually tax-free. However, the interest is taxable income if both of these apply:
    • You’re subject to the Alternative Minimum Tax (AMT).
    • You receive interest on private-activity bonds.
  • Public safety officer survivor benefits — If you’re a survivor of a public safety officer killed in the line of duty, you might be able to exclude certain income. Public safety officers include:
    • Law enforcement officers
    • Firefighters
    • Chaplains
    • Rescue squad members
    • Ambulance crew members

To learn more, see Publication 559: Survivors, Executors, and Administrators at

  • Profits on the sale of a home — If you owned and lived in your home for at least two of the five years before you sold it, you might be able exclude up to $500,000 of profit from taxable income on a joint return. If you’re single, the exclusion limit is $250,000.

    If you have a home office or rent out part of your home, then depreciation allowed after May 6, 1997, will be taxed at 25% on the profit made. As of 2009, you must subtract the amount of gain you can attribute to a period of nonqualified use from the exclusion of gain on your home’s sale. To learn more, see the Sale of a Home tax tip.

  • Roth IRA withdrawals — Withdrawals up to your contribution amounts are always tax-free. Also, after you turn 59 1/2, all withdrawals you make — including earnings — are tax-free if the account has been open for at least five years. To learn more, see the Individual Retirement Accounts (IRAs) tax tip.
  • Scholarships and fellowship grants — If you use scholarship or grant money for tuition and related expenses, the money is tax-free. This includes these required expenses:
    • Books
    • Supplies
    • Equipment

However, if you use any of the money to pay room and board, that portion is taxable income. To learn more, see Publication 970 at

  • Social Security — Depending upon your income, Social Security benefits might be entirely tax-free or partly taxable. Ex: If your income is more than $25,000 — or $32,000 if married filing jointly — up to 85% of your Social Security benefits is taxable. When figuring your income, include tax-free interest income and 50% of your Social Security benefits.
  • State and local tax refunds — You might have received a refund of your state or local income tax you claimed as an itemized deduction on your prior-year return. If so, usually a portion of your state or local income tax refund is taxable. However, even if you itemized, part of the refund could be tax-free. To learn more, see the State and Local Income Tax Refunds tax tip.
  • Veterans’ benefits — Veterans Affairs disability payments are tax-free.
  • Workers’ compensation — If you receive workers’ compensation for an injury you suffered on the job, that compensation is tax-free. However, you must receive the payment under a workers’ compensation statute or a similar statute.

To learn more, see Publication 525: Taxable and Nontaxable Income at

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