Exempt Income: Definition, How It Works, Examples, and Key Rules

Key takeaways
* Exempt income is income that is not subject to income tax at the federal or state level.
* The IRS defines federal tax exemptions; states set their own rules and may tax income differently.
* Common examples include qualified Roth distributions, interest from many municipal bonds, certain employer-provided benefits, and workers’ compensation.
* You can choose the standard deduction or itemize deductions when filing; the Tax Cuts and Jobs Act eliminated personal exemptions while raising the standard deduction.

What is exempt income?

Exempt income is earnings or benefits that are free from income tax. The Internal Revenue Service determines which items are nontaxable for federal purposes, while each state determines its own treatment for state income tax. Some items may be exempt federally but taxed by a state, or vice versa.

How it works

• Federal rules (IRS) identify categories of nontaxable income and the conditions that apply.
• States may follow federal rules or impose different rules; always check state tax law for residency-specific treatment.
• When filing federal returns you must still report many nontaxable items (or indicate them) as required; reporting rules vary by item.
• Taxpayers choose between claiming the standard deduction or itemizing deductions (medical expenses, mortgage interest, charitable gifts, etc.), which affects taxable income but is separate from exempt-income rules.

Common examples of exempt income

• Roth 401(k) and Roth IRA distributions — Qualified withdrawals (generally after meeting age and holding-period rules) are tax-free because contributions were made with after-tax dollars.
• Municipal bond interest — Often exempt from federal income tax; interest from bonds issued by your state may also be exempt from that state’s income tax.
• Health savings account (HSA) distributions — Tax-exempt only when used for qualified medical expenses.
• Employer-provided health insurance benefits — Most employer-sponsored health plan benefits are nontaxable to the employee.
• Supplemental disability insurance — Benefits funded with after-tax employee premiums are generally nontaxable.
• Workers’ compensation — Benefits for work-related injury or illness are typically exempt.
• Life insurance death benefits — Amounts paid to beneficiaries on the insured’s death are generally not included in taxable income.

Frequently asked questions

Q: What does “exempt” mean?
A: “Exempt” means free from tax; exempt income is not subject to income tax.

Q: Are unemployment benefits taxable?
A: Unemployment compensation is treated as ordinary income for federal tax purposes. State taxation of unemployment benefits varies.

Q: Are wages, salaries, and tips exempt?
A: No. Wages, salaries, tips, and most forms of compensation are taxable unless a specific exemption applies.

Q: Are municipal bonds always tax-free?
A: Municipal bond interest is commonly exempt from federal tax and may be exempt from state tax if the bond was issued by your state. Rules vary by bond type and jurisdiction.

The bottom line

Most income is taxable, but specific items are designated exempt under federal or state law. Common exempt items include qualified Roth distributions, certain municipal bond interest, some employer-provided benefits, HSAs used for qualified medical expenses, workers’ compensation, and life insurance death benefits. Because federal and state rules can differ, confirm the tax treatment of particular income items for both levels of taxation.