Legal Definitions - tax-exempt income

Tax-exempt income refers to specific types of earnings or financial benefits that are not included when calculating an individual's or organization's income tax liability at the federal, state, or local level. While this income may still need to be reported on a tax return for informational purposes, it is explicitly excluded from the amount used to determine how much income tax is owed. This differs from income that might be subject to other forms of taxation, such as gift or estate taxes, as tax-exempt income is specifically carved out from the income tax system itself.

• Example 1: Interest from Municipal Bonds
  Imagine an investor purchases bonds issued by their local city government to fund a new public library. The city pays interest to the bondholders as a return on their investment.

  How it illustrates tax-exempt income: The interest payments received from these "municipal bonds" are often exempt from federal income tax, and sometimes state and local income tax if the investor lives in the state where the bond was issued. This means that even though the investor receives regular income from these bonds, that specific income is not added to their total taxable income when calculating their income tax bill.

• Example 2: Qualified Adoption Assistance Benefits
  A company offers its employees a benefit program that provides financial assistance to help cover the costs associated with adopting a child. An employee receives $12,000 from their employer to help with legal fees and agency costs for an adoption.

  How it illustrates tax-exempt income: Under federal tax law, certain amounts of qualified adoption assistance provided by an employer can be excluded from an employee's gross income, up to a specific annual limit. This means the $12,000 received for adoption expenses, within the legal limit, would not be counted as part of the employee's taxable income, even though it is a financial benefit received from their employer.

• Example 3: Certain Scholarship Portions
  A university student receives a $25,000 scholarship. Of this amount, $18,000 is specifically designated for tuition and mandatory course fees, while the remaining $7,000 is intended to cover living expenses like room and board.

  How it illustrates tax-exempt income: The portion of a scholarship used for qualified educational expenses, such as tuition, required fees, books, and supplies, is generally considered tax-exempt income. In this scenario, the $18,000 used for tuition and fees would not be subject to income tax. However, the $7,000 designated for room and board would typically be considered taxable income because it is not for qualified educational expenses. This demonstrates that only specific portions of certain income types can be tax-exempt.