Legal Definitions - exempt income

Exempt income refers to specific types of earnings or receipts that are not subject to federal, state, or local income taxes, as defined by law. While most income is taxable, certain categories are explicitly excluded from taxation to achieve various policy goals, such as encouraging education, supporting certain populations, or promoting specific investments. This means that individuals or entities receiving exempt income do not have to report it as taxable earnings on their tax returns.

• Example 1: Scholarship for Qualified Educational Expenses

  Imagine a university student named Sarah who receives a $10,000 scholarship. She uses $8,000 of this scholarship to pay for her tuition and required course fees, and the remaining $2,000 for her living expenses, such as rent and food. The $8,000 portion of her scholarship used directly for tuition and fees is considered exempt income. Sarah does not have to report this $8,000 as taxable income on her federal tax return. However, the $2,000 she used for living expenses would typically be considered taxable income because it was not used for qualified educational expenses.

• Example 2: Life Insurance Payouts

  When Mr. Henderson passed away, his wife, Maria, received a $250,000 lump sum payment from his life insurance policy. This entire $250,000 payout is generally considered exempt income for Maria. She does not have to pay federal income tax on this money, as life insurance proceeds paid to a beneficiary are typically excluded from gross income. This exemption helps provide financial security to beneficiaries without adding a tax burden during a time of loss.

• Example 3: Interest from Municipal Bonds

  An investor, David, purchases bonds issued by his local city government to help fund the construction of a new public library. Over the year, David earns $1,500 in interest from these municipal bonds. This $1,500 in interest is generally considered exempt income from federal income tax. In many cases, it may also be exempt from state and local income taxes if David lives in the state where the bonds were issued. This tax exemption encourages investors to support public projects by making municipal bonds a more attractive investment.