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Income Exclusion Rule Explained: Understanding Tax-Free Income

Key Takeaways

The income exclusion rule defines certain types of income as non-taxable, like life insurance and child support proceeds.
Non-taxable income includes payments that cannot be used for food or shelter, such as medical or auto repair bill payments.
Income from municipal bonds is excluded up to a certain threshold, beyond which the alternative minimum tax may apply.
Social Security excludes certain incomes from taxation, based on how these relate to basic needs.
Employer-paid health insurance is a major tax exclusion that saves the Treasury significant revenues.

What Is the Income Exclusion Rule?

The income exclusion rule is a tax guideline that makes certain types of income nontaxable, meaning they are not subject to federal income tax. Under this rule, income types such as life insurance payouts, child support payments, welfare benefits, and municipal bond earnings are excluded from taxable income. By understanding which incomes qualify for exclusion, taxpayers can accurately report their earnings without unnecessary tax liabilities.1

Understanding the Income Exclusion Rule

Generally, there is no limit to the amount of this type of income that can be received. One exception is municipal bond interest, which may be counted back as an alternative minimum tax preference item.2

Income that is excluded from taxation is generally accorded this status as a measure of relief for the recipient (or else as the result of powerful lobbying, as is the case with life insurance).

How Income Exclusion Affects Social Security Benefits

For Social Security purposes, not everything an individual receives is considered income. For the most part, if an item received cannot be used as, or to obtain, food or shelter, it will not be considered as income.3

For example, if someone pays an individual's medical or automobile repair bills, or offers free medical care, or if the individual receives money from a social services agency that is a repayment of an amount he/she previously spent, that value is not considered income to the individual.

In addition, some items considered to be income are excluded when determining the amount of an individual's benefit. A detailed list of social security income exclusions can be found in section V.B of the SSI Annual Report.

Main Earned Income Exclusions

The first $65 per month plus one-half of the remainder

Impairment-related work expenses of the disabled and work expenses of the blind

Income set aside or being used to pursue a plan for achieving self-support by a disabled or blind individual

The first $30 of infrequent or irregularly received income in a quarter4

Main Unearned Income Exclusions

The first $20 per month

Income set aside or being used to pursue a plan for achieving self-support by a disabled or blind individual

State or locally funded assistance based on need

Rent subsidies under HUD programs and the value of food stamps

The first $60 of infrequent or irregularly received income in a quarter4

Tax Benefits of Employer-Paid Health Insurance

One of the biggest tax exclusions in the U.S. is the exclusion that allows workers who get job-based (or "employer-paid") health insurance coverage not to pay taxes on the value of those policies and employers to deduct the cost as a business expense.56

Internal Revenue Service. "Publication 525 (2019), Taxable and Nontaxable Income." Accessed Jan. 30, 2021.

Internal Revenue Service. "1040 and 1040-SR Instructions," Page 23. Accessed Jan. 30, 2021.

Social Security Administration. "Understanding Supplemental Security Income SSI Income -- 2020 Edition." Accessed Jan. 30, 2021.

Social Security Administration. "Income Exclusions For SSI Program." Accessed Jan. 30, 2021.

Internal Revenue Service. "Publication 525: Taxable and Nontaxable Income," Page 5. Accessed Jan. 30, 2021.

Congressional Budget Office. "Federal Subsidies for Health Insurance Coverage for People Under 65: 2020 to 2030." Accessed Jan. 30, 2021.

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