Legal Definitions - income exclusion

An income exclusion refers to specific types of income that, by law, are not included when calculating an individual's or entity's taxable income. Even though these amounts are received as income, tax regulations deem them exempt from taxation, meaning they do not contribute to the total income on which taxes are assessed. These exclusions are often established for various public policy reasons, such as encouraging certain behaviors, providing relief in specific circumstances, or avoiding double taxation.

Here are some examples of income exclusions:

• Example 1: Interest from Municipal Bonds

  A retired investor purchases bonds issued by their local city government to fund a new public park. The city pays the investor annual interest on these bonds. Under federal tax law, and often state and local tax law if the bonds are issued within the investor's state of residence, this interest income is generally not subject to income tax.

  Explanation: The interest received from these municipal bonds is an income exclusion. Even though the investor receives money (income) from the bonds, this specific type of income is legally excluded from their taxable income. This exclusion is a public policy incentive designed to encourage investment in state and local government projects.

• Example 2: Life Insurance Proceeds

  When a person passes away, their spouse receives a lump sum payment of $500,000 from a life insurance policy on the deceased spouse. This money is intended to provide financial support for the surviving spouse and their children.

  Explanation: The $500,000 received by the surviving spouse is an income exclusion. Despite being a significant financial inflow, the proceeds from a life insurance policy paid out due to the death of the insured are typically not considered taxable income for the beneficiary. This exclusion provides financial relief to families during a difficult time without adding a tax burden.

• Example 3: Qualified Fringe Benefits (e.g., Employer-Provided Health Insurance)

  An employee works for a company that provides comprehensive health insurance coverage, paying the full monthly premium of $800 directly to the insurance provider on the employee's behalf. This benefit is a significant part of the employee's overall compensation package.

  Explanation: The value of the health insurance premiums paid by the employer for the employee's benefit is an income exclusion. Although the employee effectively receives a benefit worth $800 per month, this amount is not added to their taxable wages. This exclusion is a common incentive for employers to offer health benefits and for employees to receive them, supporting public health objectives.