Eight Types of Income Internal Revenue Service Can't Touch

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Don't pay the tax man any more than you have to. 

The U.S. tax code offers some fabulous ways to cut your tax bill and keep more of your hard-earned dollars.

Want to keep the tax man away from your money? It's easier than you think.  There are lots of ways to increase your wealth without having a chunk gobbled up by the Internal Revenue Service.

It's not that the agency doesn't want your money.  It's just that the tax law prohibits the Internal Revenue Service from touching it.  And with a bit of planning, you can start to cut your current tax bill and put money in your pocket now.

Let's look at a few examples.

Not taxable except under certain conditions:

Life Insurance proceeds.  Proceeds paid to you because of the death of the insured person are usually not taxable. However, if you redeem a life insurance policy for cash, any amount that you get that is more than the cost of the policy is taxable.

Qualified Scholarship.  In most cases, income from this type of scholarship is not taxable. This means that amounts you use for certain costs, such as tuition and required books, are not taxable. On the other hand, amounts you use for room and board are taxable.

State income tax refund.  If you got a state or local income tax refund, the amount may be taxable. You should have received a 2014 Form 1099-G from the agency that made the payment to you. If you didn’t get it by mail, the agency may have provided the form electronically. Contact them to find out how to get the form. Report any taxable refund you got even if you did not receive Form 1099-G.

Usually Not Taxable:

• Gifts and inheritances
• Child support payments
• Welfare benefits
• Damage awards for physical injury or sickness
• Cash rebates from a dealer or manufacturer for an item you buy
• Reimbursements for qualified adoption expenses

For more see Publication 525, Taxable and Nontaxable Income. You can get it on www.IRS.gov/forms anytime.

 Not Taxable:

Tax-free interest
Interest earned on bonds issued by a state, territory, municipality or any political subdivision is free from federal taxes.  These are generically called municipal bonds, and their tax benefit increases in value as your marginal tax rate goes higher.  (In other words, the bonds are worth more to you as your overall income rises.)

Assume you're in the 38.6% bracket, the top rate for 2016 and 2017.  A 5% tax-free rate becomes the equivalent of a taxable rate of 8.14%.  In the 15% bracket, the taxable equivalent is only 5.88%.  If you check out www.investinginbonds.com, you can compare taxable and tax-free yields.  Compare the after-tax rates on alternative investments of equivalent risk.

Some bonds may not only be tax-free at the federal level, they may also escape state and local taxes.  If you're in the top brackets and live in New York City, this is one investment you definitely want to consider for your portfolio.

Carpool receipts
Commuting to work? Bring a friend -- and his wallet.  If you form a carpool to carry passengers to and from work, any dollars received from these passengers aren't included in your income.

Commuting costs are generally not deductible.  But if you establish a carpool and you're reimbursed in amounts sufficient to cover the cost of your repaInternal Revenue Service, gas and similar items used in connection with operating your car to and from work, then you've converted personal nondeductible expenses into excludable income.

Assume you're in the 27% bracket. You have to earn $137 per month to cover a $100 monthly commuting expense.  If you have a carpool arrangement with expenses being reimbursed, you've got no additional income.  But you do have an additional $137 per month in wealth!

Sell your house
Under a tax law enacted in 1997, if your house was your principal residence for two of the last five years, you can exclude as much as $250,000 in gain ($500,000 on a joint return) when you sell it.

You don't have to reinvest the money, and you can claim the exclusion every two years.  (If you've got $500,000 in gain every two years, I want to meet your real estate agent and go shopping!)

If you don't meet the two-year rule, you can get a partial exclusion based on the time of use and ownership. Assume you sold after only one year and had a $50,000 profit.  Your exclusion is half the $250,000, not half the $50,000 profit.  In this case, you'd pay zero tax on the sale.

But this partial exclusion is only if the sale is required because of either a change in place of employment, health reasons or unforeseen circumstances.  I haven't yet seen final regulations defining "unforeseen circumstances."  My understanding is that the Internal Revenue Service is going to be flexible here.

Tax-free compensation
When you're due for a raise, ask your company to get creative in your compensation.  There are numerous ways to receive non-taxable compensation.  Let's look at some of the best alternatives to taxable earned income.

• Use your health coverage.  Health and hospitalization insurance premiums paid by your current or former employer are tax-free -- a huge benefit.  Let's say your health insurance premiums come to $280 a month or $3,360 a year (for an HMO policy for a family of four with a $1,500 deductible).  If you're in the 27% tax bracket and have to pick up the bill, the real cost to you would be $4,603.  That's $3,360 for the premiums and $1,243 for additional income taxes because you'll be paying for the coverage in after-tax dollars.  Having your company pick up the cost helps both of you.  It doesn't have to pay the salary necessary to get you even.  It gets to write off the full cost of the coverage.  Plus, neither of you has to pay the 7.65% payroll taxes on the premiums.  And you, of course, boost your disposable income substantially.
• Cover your life.  Group term life insurance coverage of $50,000 or less paid for by your company isn't taxed to you.  You pick the beneficiary; your company pays the premiums.  Your company deducts the expense; you walk away with additional tax-free income.
• Send you to school.  Get educated.  The courses don't even have to be job-related.  But they can't be for any education involving sports, games, or hobbies.  Your company can pay, and deduct, as much as $5,250 per year in educational assistance paid for either undergraduate or graduate courses.  Again, that assistance comes to you tax-free.
• Get you there…and parked.  Your company can give you discount fare cards, passes or tokens to take public transportation to work.  As long as it's not worth more than $100 per month, your company can deduct it, but you, as an employee, receive it tax-free as a de minimus tax benefit.  You're taxed only on any excess over the $100.  If you drive and have to pay for parking, your company can provide free parking, up to a maximum value of $180 per month, to you tax-free.
• Cafeteria plans.  These are sometimes called Flexible Spending Accounts.  Your company makes deductible contributions under a written plan, which allows you to select between taxable and non-taxable benefits.  To the extent you chose non-taxable benefits, you have no additional income.  Available non-taxable benefits may include group life insurance, disability benefits, dependent care and/or accident and health benefits.  Your individual plan details the options. You make your choices among the items on the cafeteria menu.

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