Learn a Few IRS Workarounds: Some Income Comes Tax-Free

Mar 23rd 2015
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As a general rule, you have to pay taxes on all of your income—whether from wages, investments, or other sources. However, the money you receive from certain sources doesn’t count as taxable income. What follows is a list of some forms of income that entirely or partially sidestep taxes.

Prizes and awards are a mixed bag. Taxes are due on prizes won in lucky number drawings, television or radio programs, beauty contests, and similar events in which you participate as a contestant. But the law authorizes tax-free treatment for awards that are bestowed in recognition of your past accomplishments in religious, charitable, scientific, artistic, educational, literary or civic fields—for instance, the Nobel or Pulitzer prizes.

To qualify for this exemption from income, you must pass a three-step test:

  • You were named the winner without any action on your part—that is, you didn’t specifically apply for the award by, say, entering the contest or proceeding.
  • You aren’t obligated, as a condition of receiving the award, to perform substantial future services, such as teaching.
  • You donate the award money to charity. Specifically, you must "designate", that is, instruct the award-conferring organization to turn the proceeds over to one or more governmental agencies, at federal, state or local levels, or to certain charities, such as schools or churches.

Interest on bonds or other obligations issued by state or local governments is completely free of federal taxes. This break also applies to exempt-interest dividends received from mutual funds that invest in these bonds.

Interest from US Savings Bonds is reportable income. But the interest from Series EE bonds doesn’t have to be reported until you cash in the bonds. Alternatively, you can report the interest as it builds up each year without cashing in the bonds.

Education Savings Bond Program
Special rules excuse some individuals from taxes on interest from EE bonds (or I bonds) that they redeem to pay educational expenses. The interest-exemption break is available if these requirements are met: The EE bonds must be bought after 1989, owned by individuals age 24 or older, and cashed in by them during a year when they pay tuition and fees at colleges and universities for themselves or children for whom they can claim dependency exemptions. There’s no break for bonds bought in the name of a child under the age of 24 or redemption proceeds used to pay for room and board.      

Also, there’s an income test that disqualifies many individuals. The exemption begins to phase out when modified adjusted gross income (the same as adjusted gross income for most persons) is above a specified amount that’s adjusted annually to reflect inflation. For tax year 2015, the amount is $115,750 for joint filers (up from $113,950 for 2014) and $77,200 for singles and heads of household (up from $76,000 for 2014).  No exemption at all is allowed for interest received by married couples filing separate returns.

The phase-out figures are for modified adjusted gross income when the bonds are redeemed for tuition and fees, not when bought.

About the author:
Julian Block writes and practices law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator) and an attorney. More on this topic is available from “Julian Block’s Year Round Tax Strategies,” available at


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