What Is Considered Income for Federal Income Tax Reporting Purposes?

As federal employees and retirees gather their 2023 tax information in order to prepare their 2023 federal income tax returns, a commonly asked question among individuals is: What constitutes income for federal income tax reporting purposes?

This column examines the several types of income that need to be reported on an individual’s federal income tax return.

A simple rule to understand and to remember is that any income received is considered taxable by default. US citizens and resident aliens are taxed on all worldwide income. However, Congress has exempted from taxation some specific items of income from federal income tax, including:

(1) Gifts received;

(2) Inheritances received;

(3) Municipal bond interest; and

(4) Life insurance proceeds.

The following items are considered taxable income and included on one’s federal income tax return:

• Wage income. Form W-2 (Box 1 (“Taxable Wages”) represents for employees the amount of wage income and is reported on IRS Form 1040, line 1a. There are some non-wage items included on Form W-2 Box 1 and are taxable as wage income including bonuses, advances, sick pay and the lump-sum payment for unused annual leave that is paid to a federal employee when he or she leaves or retires from federal service.

• Non-taxable fringe benefits provided to federal employees by the federal government that appear in Form W-2, Box 12. These fringe benefits include:

(1) Excludable moving expense reimbursements paid directly to a member of the US Armed Forces;

(2) Agency contributions made to an employee’s Health Savings Account;

(3) Agency-paid FEHB program health insurance premiums; and

(4) Agency contributions to a FERS-employee’s traditional TSP account. A taxable fringe benefit provided to employees (and included in Box 1, Box 3 and Box 5 of Form W-2) is the taxable cost of the FEGLI Basic Insurance Amount (BIA) in excess of $50,000 paid by an agency on behalf of an employee. The amount included as taxable income appears with a code “C” in Box 12.

• Investment income. Any investment income including interest, dividends, and capital gains received by an individual from non-retirement bank or brokerage accounts is income that must be reported on an income tax return. Banks and brokerages are required to report to account holders and investors the amount of their investment income each year on a Form 1099 (in particular, Form 1099-INT, 1099-DIV, 1099-B). However, if the amount paid by an institution to an investor is less than $10, most banks and brokerages do not issue a Form 1099. Nevertheless, the account owner must still report the investment income on his or her income tax return even if it is less than $10.

• Retirement plans, pensions and annuities. The general rule says that distributions from traditional retirement plans of all types are taxable. These retirement plans include traditional IRAs including contributory IRAs, SEP IRAs and SIMPLE IRAs, the Thrift Savings Plan, 401(k), 403 (b), 457 retirement plans and annuities.

Note the following:

(1) Those individuals who are retired public safety officers who can elect to exclude from income distributions of up to $3,000 (for 2023, increased to $6,000 starting January 1, 2024) made directly from a government retirement plan to the provider of accident, health, or long-term care insurance;

(2) Borrowings (loans) from retirement plans, such as the TSP;

(3) Direct trustee-to-trustee IRA transfers are usually non-taxable; and

(4) Amounts converted from traditional IRAs to Roth IRAs are taxable in the year of conversion.

• Rental income. Net rental income (or loss) resulting from the rental of any type of property (real estate, personal items and equipment).

• Social Security benefits. As much as 85 percent of an individual’s Social Security disability or retirement benefits may be included in an individual’s gross income each year for federal income tax purposes.

When federal employees prepare their 2023 federal income tax returns using IRS Form 1040, they will find on line 8 of 2023 Form 1040 “Additional income from Schedule 1, line 10 of Form 1040”. See below.

A portion of 2023 Schedule 1 of Form 1040 (under Part I – “Additional Income”) showing these income items is presented here:

The following is an explanation on some of the items listed on lines 1 through 8 of Form 1040, Schedule 1 Part I (“Additional Income”):

• Line 1. Taxable refunds, credits, or offsets of state and local income taxes. Individuals who received a refund of state or local taxes on a previous year’s state and local income tax return may receive a Form 1099-G (Certain Government Payments) from their state revenue department showing the amount of the previous year’s state or local tax refund. But not every individual must include the state or local tax refund as part of their 2023 gross income for federal income tax purposes.

An individual need not claim a prior year’s state income tax refund as income on their 2023 federal income tax return if the individual:

(1) Claimed the standard deduction on the tax return for the year they received a refund of state or local income taxes;

(2) Owed the alternative minimum tax (AMT) in the prior year, or

(3) Could be claimed as a dependent by someone else in the prior year. Only those individuals who itemized deductions on their federal income tax return and received a federal income tax benefit for deducting their state income taxes may have to include their state/local tax refunds in income on their federal income tax return. Also, none of the refund is taxable if an individual itemized deductions and included the state sales tax instead of the state income tax withheld as part of their itemized deductions.

•Line 2. Alimony received. This is applicable only if the alimony received during 2023 is a result of a divorce settlement that occurred before January 1, 2019.

•Line 7. Unemployment compensation. Any individual who received unemployment compensation during 2023 should have received a Form 1099-G showing the amount of unemployment compensation paid in Box 1 of Form 1099-G.

•Line 8a. Net operating loss. Enter any NOL deduction from an earlier year. Enter the amount in the preprinted parentheses (as a negative number). The amount of the deduction will be subtracted from the other amounts of income listed on lines 8b through 8z.

•Line 8b. Gambling. Enter any gambling winnings. Gambling winnings include lotteries, raffles, or a lump sum payment from the sale of a right to receive future lottery payments.

•Line 8c. Cancellation of debt. Enter any canceled debt. Canceled debt may be shown in box 2 of Form 1099-C. However, part or all of an individual’s income from cancellation of debt may be nontaxable.

•Line 8d. Foreign earned income exclusion from Form 2555. Enter the amount of your foreign earned income and housing exclusion from Form 2555, line 45. Enter the amount in the preprinted parentheses as a negative. The amount from Form 2555 line 45 will be subtracted from the other amounts of income listed on lines 8a through 8c and lines 8e through 8z.

•Line 8f. Income from Form 8889. Enter the total of the amounts from Form 8889 lines 16 and 20. This total of taxable Health Savings Account (HSA) distributions during 2023.

What Is Considered Income for Federal Income Tax Reporting Purposes?

•Line 8i. Prizes and awards. Enter prizes and awards received during 2023.

•Line 8k. Stock options. Enter any income from the exercise of stock options not otherwise reported on Form 1040.

•Line 8z. Other income. Use line 8z to report any taxable income not reported elsewhere on the tax return or other schedules. List the type and amount of income. If necessary, include a statement showing the required information. Examples of income to report on line 8z include the following:

• Reimbursements or other amounts received for items deducted in an earlier year, such as medical expenses, real estate taxes, general sales taxes, or home mortgage interest.

• Reemployment trade adjustment assistance (RTAA) payments. These payments should be shown in box 5 of Form 1099-G.

• Loss on certain corrective distributions of excess deferrals.

• Dividends on insurance policies if they exceed the total of all net premiums you paid for the contract

• Taxable distributions from a Coverdell education savings account (ESA) or a qualified tuition program (QTP). Distributions from these accounts may be taxable if

(a) in the case of distributions from a QTP, they are more than the qualified higher education expenses of the designated beneficiary in 2023 or, in the case of distributions from an ESA, they are more than the qualified education expenses of the designated beneficiary in 2023; and

(b) they were not included in a qualified rollover. Nontaxable distributions from these accounts do not have to be reported on Form 1040. This includes rollovers and qualified higher education expenses refunded to a student from a QTP that were recontributed to a QTP with the same designated beneficiary within 60 days after the date of refund.

Federal employees who have any problems or questions about what should be included as income on their 2023 federal income tax return are advised to talk to a tax professional who is familiar with the IRS rules regarding the types of income included in gross income on an individual’s federal income tax return.