Individual Tax briefs

6 tax-free income opportunities

Believe it or not, there are ways to collect tax-free income and gains. Here are some of the best opportunities to put money in your pocket without current federal income tax implications:

1. Roth IRAs offer tax-free income accumulation and withdrawals. Unlike withdrawals from traditional IRAs, qualified Roth IRA withdrawals are free from federal income tax. A qualified withdrawal is one that’s taken after you’ve reached age 59½ and had at least one Roth IRA open for over five years, or you are disabled or deceased. After your death, your heirs can take federal-income-tax-free qualified Roth IRA withdrawals, with proper planning.
2. A large amount of profit from a home sale is tax-free. In one of the best tax-saving deals, an unmarried seller of a principal residence can exclude (pay no federal income tax on) up to $250,000 of gain, and a married joint-filing couple can exclude up to $500,000. That can be a big tax-saver, but you generally must pass certain tests to qualify. For example, you must have owned the property for at least two years during the five-year period ending on the sale date. And you must have used the property as a principal residence for at least two years during the same five-year period. Note: To be eligible for the larger $500,000 joint-filer exclusion, at least one spouse must pass the ownership test and both spouses must pass the use test.
3. People with incomes below a certain amount can collect tax-free capital gains and dividends. The minimum federal income tax rate on long-term capital gains and qualified dividends is 0%. Surprisingly, you can have a pretty decent income and still be within the 0% bracket for long-term gains and dividends — based on your taxable income. Single taxpayers can have up to $47,025 in taxable income in 2024 and be in the 0% bracket. For married couples filing jointly, you can have up to $94,050 in taxable income in 2024.
4. Gifts and inheritances receive tax-free treatment. If you receive a gift or inheritance, the amount generally isn’t taxable. However, if you’re given or inherit property that later produces income such as interest, dividends, or rent, the income is taxable to you. (There also may be tax implications for an individual who gives a gift.) In addition, if you inherit a capital gain asset like stock or mutual fund shares or real estate, the federal income tax basis of the asset is stepped up to its fair market value as of the date of your benefactor’s demise, or six months after that date if the estate executor so chooses. So, if you sell the inherited asset, you won’t owe any federal capital gains tax except on appreciation that occurs after the applicable date.
5. Some small business stock gains are tax-free. A qualified small business corporation (QSBC) is a special category of corporation. Its stock can potentially qualify for federal-income-tax-free treatment when you sell for a gain after holding it for over five years. Ask us for details.
6. You can pocket tax-free income from college savings accounts. Section 529 college savings plan accounts allow earnings to accumulate free of any federal income tax. And when the account beneficiary (typically your child or grandchild) reaches college age, tax-free withdrawals can be taken to cover higher education expenses. Alternatively, you can contribute up to $2,000 annually to a Coverdell Education Savings Account (CESA) set up for a beneficiary who hasn’t reached age 18. CESA earnings are allowed to accumulate free from federal income tax. Then, tax-free withdrawals can be taken to pay for the beneficiary’s college tuition, fees, books, supplies, and room and board. The catch: Your right to make CESA contributions is phased out between modified adjusted gross incomes of $95,000 and $110,000, or between $190,000 and $220,000 if you’re a married joint filer.

Advance planning may lead to better results 

You may be able to collect federal-income-tax-free income and gains in several different ways, including some that aren’t explained here. For example, proceeds from a life insurance policy paid to you because of an insured person’s death generally aren’t taxable. So, don’t assume you’ll always owe taxes on income. Also, check with us before making significant transactions because advance planning could result in tax-free income or gains that would otherwise be taxable.

Working remotely is convenient, but it may have tax consequences

Many employees began working remotely during the pandemic and continue doing so today. Remote work has many advantages for employers and employees, and as a result, it’s here to stay in many industries. But it may also lead to some tax surprises, especially if workers cross state lines.

Double taxation may occur

It’s not unusual for employees to work remotely for an employer in another state. For some businesses, remote work has become a permanent arrangement that allows employees to live and work further away from a physical office.

If you live in one state and work remotely for an employer in another state, familiarize yourself with the tax laws in both states and determine how they may affect you. For example, you may need to file income tax returns in both states, which could result in increased — or even double — taxation.

Here’s the problem: A state generally has the power to tax the incomes of people who are domiciled in it as well as people who reside there. Domicile is a state of mind and is often based on a person’s intent to make a location his or her “true, fixed, permanent home.” Residency is based on physical presence in a state for a certain amount of time (typically, 183 days per year).

It’s possible to be domiciled in one state and a resident of another. For example, let’s say you have a permanent home in one state where your job is located and a vacation home in another state. Your employer allows employees to work remotely, so now you spend more than 200 days per year living and working at your vacation home. The state where your permanent home is located considers you to be domiciled there, but the state where your vacation home is located views you as a resident. So you may be subject to taxes on the same income in both states. You could avoid double taxation if one or both states provide credit for tax paid to other states. But your tax bill may still increase if, for example, one state’s income tax rate is significantly higher than the other state’s rate.

Complications for employers

From an employer’s perspective, allowing employees to work remotely may create obligations to withhold and remit income and payroll taxes in several states. Plus, having employees in other states may be sufficient to establish “nexus” with those states, potentially triggering liability for their income, franchise, gross receipts, or sales and use tax. In addition to the expense of tax reporting in multiple states, this may increase an employer’s overall tax liability. There are other complications as well.

Business expense deductions

Under current law, employees generally can’t deduct unreimbursed job-related expenses. Years ago, employees could claim certain costs as miscellaneous itemized deductions, which are deductible to the extent they exceed 2% of adjusted gross income. But those deductions were eliminated for 2018 through 2025.

Remote workers typically aren’t eligible for the home office deduction either. That deduction is generally limited to self-employed business owners. Prior to 2018, employees could claim the deduction if, among other things, they worked at home “for the convenience” of their employers. But that deduction was also eliminated for 2018 through 2025.

Employers may reimburse remote workers for their business expenses according to an “accountable plan” that requires employees to substantiate expenses and meet other requirements. Properly reimbursed expenses are deductible by an employer and excludable from an employee’s income.

Be aware of the consequences

If you’re a remote worker or own a business that employs remote workers, be sure you understand the tax implications. In some cases, you may be able to take steps to minimize them. But even if you can’t, it’s important to know what to expect.

Are you unfairly burdened by a spouse’s tax errors? You may qualify for “innocent spouse relief”

Navigating the complexities of tax law can be difficult, especially when faced with an unexpected tax bill due to the errors of a spouse or ex-spouse. The reason for such a bill has to do with the concept of “joint and several” liability. When a married couple files a joint tax return, each spouse is liable for the full amount of tax on the couple’s combined income. Therefore, the IRS can come after either spouse to collect the entire tax — not just the part that’s attributed to one spouse or the other. This includes any tax deficiency that the IRS assesses after an audit, as well as any penalties and interest.

There may be relief

In some cases, spouses are eligible for “innocent spouse relief.” This generally involves an individual who was unaware of a tax understatement that was attributable to his or her spouse. To qualify, you must show that you didn’t know about the understatement and that there was nothing that should have made you suspicious. In addition, the circumstances must make it inequitable to hold you liable for the tax.

This relief is available even if you’re still married and living with your spouse. In addition, individuals may be able to get relief for tax deficiencies on joint returns if they’re divorced, widowed, legally separated or living apart.

Recent court cases

Not surprisingly, the issue of innocent spouses is frequently litigated. Here are some cases from this year:

• Taxpayer wins. In one case, it was undisputed that a married couple’s joint tax return included an understatement of tax. The IRS and the wife agreed that she didn’t know, or have reason to know, that the correct amount of taxes wasn’t paid. She wasn’t involved in her now ex-husband’s employment or business activities. He concealed his finances from her and kept separate bank accounts. The U.S. Tax Court weighed all factors and found it would be inequitable to hold her liable for the deficiency. Her request for innocent spouse relief was granted. (TC Memo 2024-26)
• Taxpayer loses. In another case, a widow argued that if she paid the taxes owed by her deceased husband, she’d suffer economic hardship. Her annual income, she testified, was far below the poverty line and her assets were insufficient to pay the taxes. However, she failed to provide evidence to support her income or the value of her two homes. Records showed that while her income taxes remained unpaid, she enjoyed significant benefits, including several expensive vacations and the purchase of a luxury vehicle. The U.S. Tax Court denied her request for relief. (162 TC No. 2)

An “injured spouse”

In addition to innocent spouse relief, there’s also relief for an “injured spouse.” What’s the difference? An injured spouse claim asks the IRS to allocate part of a joint refund to one spouse. In these cases, all or part of an injured spouse’s refund from a joint return is applied against past-due federal tax, state tax, child or spousal support, or a federal nontax debt (such as a student loan) owed by the other spouse. If you’re an injured spouse, you may be able to recoup your share of the refund.

A challenging process

Whether, and to what extent, you can take advantage of the above relief depends on the facts of your situation. If you’re interested in trying to obtain relief, there’s paperwork that must be filed and deadlines that must be met. We can assist you with the details.

Also, keep “joint and several liability” in mind when filing future tax returns. Even if a joint return results in less tax, you may choose to file a separate return if you want to be certain you’re responsible only for your own tax. Contact us with any questions or concerns.

Do you owe estimated taxes? If so, when is the next one due?

Federal estimated tax payments are designed to ensure that certain individuals pay their fair share of taxes throughout the year. If you don’t have enough federal tax withheld from your paychecks and other payments, you may have to make estimated tax payments. This is the case if you receive interest, dividends, self-employment income, capital gains, a pension or other income that’s not covered by withholding.

Individuals must pay 25% of a “required annual payment” by April 15, June 15, September 15, and January 15 of the following year, to avoid an underpayment penalty. If one of those dates falls on a weekend or holiday, the payment is due on the next business day.

So the third installment for 2024 is due on Monday, September 16 because the 15th falls on a Sunday. Payments are made using Form 1040-ES.

The amount due

The required annual payment for most individuals is the lower of 90% of the tax shown on the current year’s return or 100% of the tax shown on the return for the previous year. However, if the adjusted gross income on your previous year’s return was more than $150,000 ($75,000 if you’re married filing separately), you must pay the lower of 90% of the tax shown on the current year’s return or 110% of the tax shown on the return for the previous year.

Most people who receive the bulk of their income in the form of wages satisfy these payment requirements through the tax withheld by their employers from their paychecks. Those who make estimated tax payments generally do so in four installments. After determining the required annual payment, divide that number by four and make four equal payments by the due dates.

But you may be able to use the annualized income method to make smaller payments. This method is useful to people whose income flow isn’t uniform over the year, perhaps because of a seasonal business. For example, if your income comes exclusively from a business operated in a resort area during June, July, and August, no estimated payment is required before September 15.

The underpayment penalty

If you don’t make the required payments, you may be subject to an underpayment penalty. The penalty equals the product of the interest rate charged by the IRS on deficiencies, times the amount of the underpayment for the period of the underpayment.

However, the underpayment penalty doesn’t apply to you if:

• The total tax shown on your return is less than $1,000 after subtracting withholding tax paid;
• You had no tax liability for the preceding year, you were a U.S. citizen or resident for that entire year, and that year was 12 months;
• For the fourth (January 15) installment, you file your return by that January 31 and pay your tax in full; or
• You’re a farmer or fisherman and pay your entire estimated tax by January 15, or pay your entire estimated tax and file your tax return by March 1.

In addition, the IRS may waive the penalty if the failure was due to casualty, disaster or other unusual circumstances and it would be inequitable to impose the penalty. The penalty can also be waived for reasonable cause during the first two years after you retire (and reach age 62) or become disabled.

We can help

Contact us if you need help figuring out your estimated tax payments or you have other questions about how the rules apply to you.

The tax implications of disability income benefits

Many Americans receive disability income. Are you one of them, or will you soon be? If so, you may ask: Is the income taxed and if it is, how? It depends on the type of disability benefit and your overall income.

The key issue is: Who paid for the benefit? If the income is paid directly to you by your employer, it’s taxable to you just as your ordinary salary would be. (Taxable benefits are also subject to federal income tax withholding. However, depending on the employer’s disability plan, in some cases they aren’t subject to Social Security tax.)

Frequently, the payments aren’t made by an employer but by an insurance company under a policy providing disability coverage. In other cases, they’re made under an arrangement having the effect of accident or health insurance. In these cases, the tax treatment depends on who paid for the insurance coverage. If your employer paid for it, then the income is taxed to you just as if it was paid directly to you by the employer. On the other hand, if it’s a policy you paid for, the payments you receive under it aren’t taxable.

Even if your employer arranges for the coverage (in a policy made available to you at work), the benefits aren’t taxed to you if you (and not your employer) pay the premiums. For these purposes, if the premiums are paid by the employer but the amount paid is included as part of your taxable income from work, the premiums will be treated as paid by you. In these cases, the tax treatment of the benefits received depends on the tax treatment of the premiums paid.

Illustrative example

Let’s say your salary is $1,050 a week ($54,600 a year). Additionally, under a disability insurance arrangement made available to you by your employer, $15 a week ($780 annually) is paid on your behalf by your employer to an insurance company. You include $55,380 in income as your wages for the year ($54,600 paid to you plus $780 in disability insurance premiums). Under these circumstances, the insurance is treated as paid for by you. If you become disabled and receive benefits under the policy, the benefits aren’t taxable income to you.

Now assume that you include only $54,600 in income as your wages for the year because the amount paid for the insurance coverage qualifies as excludable under the rules for employer-provided health and accident plans. In this case, the insurance is treated as paid for by the employer. If you become disabled and receive benefits under the policy, the benefits are taxable income to you.

There are special rules if there is a permanent loss (or loss of the use) of a member or function of the body or a permanent disfigurement. In these cases, employer disability payments aren’t taxed, as long as they aren’t computed based on amount of time lost from work.

Social Security disability benefits 

This discussion doesn’t cover the tax treatment of Social Security Disability Insurance (SSDI) benefits. They may be taxed to you under the rules that govern Social Security benefits. These rules make a portion of SSDI benefits taxable if your annual income exceeds $25,000 for individuals and $32,000 for married couples.

State rules may differ

If you receive disability benefits, your state may or not tax them. Consult with us to find out and to discuss this issue further.

When deciding how much disability coverage you need to protect yourself and your family, take the tax treatment into consideration. If you’re buying a private policy yourself, you only have to replace your “after tax” (take-home) income because your benefits won’t be taxed. On the other hand, if your employer is paying for the benefit, keep in mind that you’ll lose a percentage of it to taxes. If your current coverage is insufficient, you may want to supplement the employer benefit with a policy you take out on your own.