Exemptions to the Income Tax, or What Don’t We Tax?

The income tax takes a portion of a person’s total income in tax for the government, but there are important exceptions to this that allow a person to minimize how much it is that the government takes. The exceptions for sources of income are for both practicality and fairness, acknowledging that people cannot pay taxes with money they already have and exempting from taxes things like personal injury payouts, because it isn’t an income but a compensation for something lost.

The exemptions from taxation for uses serve a different purpose; in encouraging people to save their money, they are shifting the tax from a general income tax to a consumption tax. With these exemptions, people are taxed on wealth when they are spending it; these exemptions focus the tax on the consumption of wealth for people with un-exempted incomes.

Sources

Unrealized Gains

Unrealized gains are the increase in value of capital that has not yet been sold. These gains cannot be taxed until the capital is sold, creating a “ticking tax time-bomb.” This makes sense, because they do not result in an increased amount of money on hand (if they did, they wouldn’t be unrealized) and may lose value in the future.

Many people gained value in their houses from 2000-2008; theoretically, the government could have charged them taxes every year for the increase in their wealth. But then a lot of those gains were wiped out when the housing market crashed at the end of 2008. It is easy to understand why it would be unfair for the government to charge taxes as the value increased; people may not have been able to afford the taxes since the increased wealth wasn’t increased money and when the property eventually lost value, they would have paid taxes for wealth they never received.

When capital that has successfully appreciated is then sold, that increase in value becomes realized and is capital gains, discussed in What Do We Tax?

Inheritance

It turns out, taxes put the fun into funeral, for two reasons: first, the recipient of the inheritance is never taxed on their newfound wealth; and second, the unrealized gains are reset so that there is no built-in tax to any capital that is inherited. (In some circumstances, the decedent is taxed, but this is exceedingly rare and easily avoided, so it is not even worth explaining.)

The first wonderful thing means that you never have to pay taxes on the money you’ve inherited, which is very generous of Uncle Sam, because you were busy using those dolla dolla bills to wipe away your grieving tears. It also means that the family home doesn’t have to be sold to pay off your new tax bill.

The second wonderful thing is even better. Resetting unrealized gains means that, at the time of your inheritance: there are none! Your grandparents may have spent $1 Million on their house in 1970 and that house is worth $4 Million at the time of their death, when you inherit it. If they had sold it before they died, they would have had to pay capital gains taxes on $3 Million. ($4 Million at sale - $1 Million at purchase = $3 Million taxable gains) Instead, when you eventually sell it for $6 Million, you only have to pay capital gains taxes o $2 Million! This is because, when you inherited it, the change in value is reset to its value at that time and gains start accumulating anew. ($6 Million value at sale - $4 Million value at inheritance = $2 Million taxable gains)

This makes for easier bookkeeping and it provides for the perfect loophole from taxation, which we will explain later with Tax Planning 101: Buy, Borrow, Die. (If only receiving a house were actually this easy)

Uses

Retirement Savings

Taxes can be deferred for up to $19,000 that is saved through qualified means. That means that the taxes are deductible from your taxes this year but taxes must be paid on the full amount when they are sold. This is especially useful for shifting income into a time where you will be taxed in a lower tax bracket and is done to encourage people to save for retirement.

If you have an income of $100,000 and put $10,000 into your retirement savings, then this year you will be taxed based on a salary of $90,000. ($100,000 - 10,000 = $90,000) When you are retired and finally take that $10,000 out to pay for your groceries and gas, it will be taxed as $10,000 earned that year, which means you will be in a lower tax bracket (because you no longer have a full salary) and pay a lower percentage in taxes of that $10,000 that you earned while you were in a higher bracket.

(Some) Business Investments

Business investments are similar to retirement savings. Qualified business investments are deferred from taxes until the investment is sold. Depending on the type of investment, the entire investment can be deferred immediately, the investment can be deferred year-by-year, or the investment can be taxed immediately and treated as capital gains.

Employer-Provided Health Insurance

Money that is used for health insurance through an employer and some medical expenses are deductible. This means that your “income” for the purposes of taxation is lowered by this amount and no taxes are paid on this money. If you have an income of $100,000 and spend $10,000 on your health insurance, you will be taxed based on a salary of $90,000. This reflects the fact that, because of their necessity, we don’t really think of medical expenses as taxable spending.

Other People’s Money

Taking debt does not, from an economic perspective, create wealth. This makes sense; a loan of $1,000 gives you cash but means that you owe the lender that back, plus interest. Paying off debt, however, is a type of savings; if you have paid off $100 of your loan, then you only owe the lender $900 (it has increased your net worth). Taking debt is not taxed. Paying off debt is not an exempted form of savings. That means that post-tax dollars are used to pay off debt, so the debt is effectively taxed when it is paid back and not when it is taken.