There are numerous ways to generate passive income, but unfortunately, the vast majority of them are taxable. This is especially true of income-generating investments, of which only a handful allow you to avoid taxation.
Tax-Free Municipal Bonds
Buying municipal bonds is the simplest and one of the only methods to generate tax-free income from your investments. Municipal bonds are generally exempt from federal taxation. Typically, residents of the same state as the issuer also receive a state-level tax benefit. However, if applicable, capital gains are fully taxable.
Inheritance
You will not be required to pay federal tax on any inheritances you receive, regardless of their size. In certain instances, the deceased may be required to pay estate taxes, but this is of no concern to the beneficiaries. However, six states do impose an inheritance tax on beneficiaries, so you will need to confirm whether all of your proceeds are tax-free.
Life Insurance Benefits
If you are the beneficiary of a life insurance policy, the proceeds will be transferred to you tax-free. This is the case even if you receive a policy worth $1 million or more. Note that if you cash in a life insurance policy instead of receiving the mortality benefit, you will likely owe tax on some or all of the proceeds.
Disability Payments
In certain instances, disability payments may constitute taxable income. If you pay all premiums for a health or accident insurance plan, however, your disability payments are not deemed taxable income.
Gifts
Gifts may be taxable to the donor if they exceed the annual exclusion amount, which for 2023 is $17,000 per individual. However, recipients of gifts are never required to pay tax on their offerings.
Alimony
Prior to 2019, alimony was tax-deductible for the payer and taxable for the recipient. After that date, payers could no longer deduct alimony payments and recipients were no longer required to pay tax on them. However, keep in mind that some states, such as California, do not follow this federal change and continue to tax alimony.
Child Support.
Like alimony, according to the IRS, child support payments are neither deductible by the provider nor taxable by the recipient.
Roth IRA Distributions
In contrast to traditional IRAs, distributions from Roth IRAs are typically tax-free. As long as your withdrawals are “qualifying,” which generally means you’ve held the account for at least five years and are older than 59.5, you won’t have to pay tax on any money you withdraw, including interest and capital gains.
Disaster Mitigation Payments
Your state or local government may provide you with a disaster mitigation payment if you experience a natural disaster. These contributions are not subject to taxation.
Acceptable Adoption Expense Reimbursements
In addition to qualifying for a tax credit for qualified adoption expenses, you can also exclude from income employer-provided adoption assistance payments.
Appropriated HSA Contribution Distribution
You are permitted to make a one-time transfer from your IRA to your HSA without incurring tax liability.
State With No Income Tax Income
Alaska, South Dakota, Nevada, Florida, Texas, Wyoming, Washington, and Tennessee are the eight states that currently do not tax federally taxable income. This is one of the few instances in which regular taxable income is exempt from taxation. Even if you reside in a state with no income tax, you will still be required to pay federal taxes on your income.
Let us know if you need any help.
Contact Surya Padhi at Sure Financials for any questions and clarification. Surya Padhi is an expert who keeps current on tax law changes as well as a member of the National Association of Tax Professionals National Association of Tax Professionals (NATP) and National Association of Enrolled Agents (naea.org). Visit Welcome | Sure Financials & Tax Services, LLC (surefintaxsvs.com) for more information and contact us by calling +1 908.300.9193.
