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Tax-Free Income (Part 2)

Appeared in the Columbia Daily Tribune on 5/11/19

In my last article I mentioned six types of tax-free income:  1) Muni bonds, 2) Life insurance proceeds, 3) Nonqualified retirements accounts, 4) Charitable Remainder Trusts, 5) Per diem deductions, and 6) Mileage deductions. There are other kinds of tax-free income. Hence the need for Tax-Free Income, Part 2.

Here are the types of tax-free income I will explain in this article:

1. Flexible Spending Accounts (FSA, aka cafeteria plans)

2. Roth IRA distributions

3. 529 Plans

4. Social security benefits

5. Disability benefits

6. Workman’s compensation benefits

7. Legal awards for restitution

8. Garage sales

Since the implementation of the Affordable Care Act (ACA), the annual limits of medical Flexible Spending Accounts have been reduced. Also, medical FSAs have lost popularity since the arrival of Health Savings Accounts (HSAs). Dependent care FSAs are still popular and function the same way as medical FSAs. They must be provided as a benefit by your employer. You can’t set up an FSA on your own. 

The reason I consider FSAs as tax-free income is those funds avoid all income and payroll taxes. More than 10 years ago, when our two sons were still at home, we regularly put the annual limit of $5,000 in an FSA via payroll deduction. It let Uncle Same help us pay for braces, emergency visits, copays and deductibles that weren’t covered by traditional health insurance. Sure, an FSA isn’t technically income, but if the IRS and Social Security never touch that money, I call it tax-free income.

The Roth Individual Retirement Arrangement (Roth) results in tax-free income to the owner. Contributions are made with after-tax dollars, but the IRS never taxes any portion of the distribution received during retirement. However, earnings can be subject to taxes if withdrawn before age 59 ½. If used properly, the earnings from the invested funds are never taxed! Also, unlike an IRA, a Roth avoids most of the burdensome requirements that follow those funds into the pockets of your heirs. I have seen wealthy people (who have already secured a comfortable retirement) use their Roth accounts for riskier investments. If a certain investment goes bankrupt, they would have lost that money anyway. But, if a Roth investment goes crazy and produces a 1,000% return, none of it is taxable (if not touched until retirement).

I have included 529 college savings plans as tax-free income because the investment earnings are not subject to income taxes. Investments in a 529 do not result in a federal tax deduction. However, the State of Missouri allows a state tax deduction for contributions to the MOST 529 plan. There are annual limits. The main point is that the investment earnings of a 529 plan avoid all income taxes, if the funds are used for approved educational purposes.

I cannot cover tax-free income without mentioning Social Security Benefits. If your income falls under a certain amount, your benefits won’t be taxed. That threshold changes every year. After a phase-in period, up to 85% of your SS benefits an be taxed. But, at modest income levels one’s SS benefits will be tax-free.

The taxation of disability benefits varies by type and policy. Most disability benefits that I have seen involving a permanent disability are not taxable. Generally, if your employer pays for the premiums for short or long-term disability insurance, then the benefits are taxable to you. If you pay the premiums, then the benefits are tax-free.

Workers’ Compensation benefits are usually not subject to taxes. However, some of those benefits may become taxable if you also receive Social Security Disability Income (SSDI) or Supplemental Security Income (SSI). Most benefits paid by Social Security can be subject to income taxes (like regular SS benefits) if your income is more than a certain income threshold. Awards for the permanent loss of a finger, for example, are not subject to income taxes because they are considered a monetary reimbursement for that loss.

It is my hope that you never suffer a loss related to personal injury. But if you win a lawsuit or settlement for a personal injury, those proceeds are not subject to income taxes. You need to be careful to make sure the purpose of the payment is clearly specified, because payments for punitive or legal injuries (for example, wrongful termination) are taxable!

Let’s say you have nice junk have a garage sale on Saturday and make $500. That income is not taxable. Even though you think of it as newly found income, when compared to your cost the result is a loss. Unfortunately, losses on the sale of personal property are not deductible. So, just be glad you don’t have to report and pay taxes on that $500. But, if you turn selling junk into a business, you will need to pay taxes on your income as well as register, collect and remit sales taxes. You are safe if you have a couple garage sales this year.

I may not have covered all types of tax-free income, but I trust I have answered a few questions in the back of their minds of some people.

Aric Schreiner, CPA, PFS, CTP is the Senior Tax Reduction Strategist and founder of Columbia CPA Group, who helps successful professionals and small business owners strategize to reduce taxes while reducing audit risk.


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