As federal employees and retirees gather together their 2021 tax information and income-related documents in order to prepare their 2021 federal income tax returns, a commonly asked question among individuals is what constitutes income for federal income tax reporting purposes.
This column examines the various types of income that are reported on an individual’s federal income tax return.
A simple rule to understand and to remember is that the various types of income are considered taxable by default. US citizens and resident aliens are taxed on all worldwide income.
However, Congress has exempted from taxation some specific items from federal income tax, including: (1) Gifts received;(2) Inheritances received; (3) Personal residence rental for less than 15 days in a year; (4) Municipal bond interest; and (5) Life insurance proceeds.
The following items are considered taxable income and included as such on one’s federal income tax return. Those states that have state and local income taxes generally follow federal income tax rules:
• Wage income. Form W-2 Box 1 (“Taxable Wages”) represents for employees the amount of wage income reported on IRS Form 1040 line 7. Many “non-wage” items are 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 are included 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) the amount of agency paid FEHB program health insurance premiums; and
(4) agency contributions to a FERS-employee’s traditional TSP account. One 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 FEGLI “basic” life insurance 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.
• Workers’ Compensation. Amount received as workers’ compensation for an occupational sickness or injury is fully exempt from income tax if the amount paid is under a workers’ compensation act or a statute in the nature of a workers’ compensation act. Note that the exemption does not apply to retirement benefits an individual receives based on one’s age, length of service or prior contributions to a retirement plan, even if the individual retired because of an occupational sickness or injury.
• Stimulus checks are not taxable. In 2021, many federal employees like other Americans received a third stimulus check as a result of the passage of the American Rescue Plan Act. The third stimulus was based primarily on 2020 adjusted gross income levels. Many individuals did not qualify the third stimulus payment due to higher income levels. But for the individuals who did qualify, the payment was worth up to $1,400 for each eligible adult and each qualifying dependent in a household. Any excess payments do not have to be repaid and the payments are not taxable.
• Retirement plans, pensions and annuities. The general rule says that distributions from 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.
There are some exceptions including:
(1) those individuals who are retired public safety officers who can elect to exclude from income distributions of up to $3,000 made directly from a government retirement plan to the provider of accident, health, or long-term disability 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. Transfers of traditional TSP to Roth IRAs are taxable in the year of transfer.
• Investment income. Any investment income such as 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 (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.
• Rental income. Net rental income resulting from the rental of any type of property (real estate, personal items and equipment) must be included in income.
• Social Security benefits. As much as 50 or 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.
The following is copy of a portion of 2021 IRS Form 1040 showing the items discussed above:
There are additional types of income to be included on one’s federal income tax return. These items appear on Schedule 1 of Form 1040. A portion of 2021 Schedule 1 of Form 1040 (under Part I – “Additional Income”) showing these items is presented here:
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Note the following additional items to income:
(1) Alimony received (if the alimony was a result of a divorce settlement that occurred before January 1, 2018);
(2) Unemployment compensation;
(3) Gambling income;
(4) Cancellation of debt;
(5) Taxable Health Savings Account (HSA) distribution;
(6) Jury duty pay; and
(7) Prizes and awards.
Also, line 1 of Part 1 of Form 1040 Schedule 1 is “taxable refunds, credits, or offsets of state and local income taxes”. A discussion of whether a state or a local tax refund is taxable is presented here.
• State tax refunds. Individuals who received a refund of state or local taxes on previous years’ state and local income tax returns may receive a Form 1099-G (Certain Government Payments) from their state revenue department showing the amount of the previous year state or local tax refund. But not everyone must include the state or local tax refund as part of their 2021 gross income. The following individuals need not claim a prior year’s state income tax refund as income on their 2021 federal income tax return:
(1) Individuals who claimed the standard deduction on the tax return for the year they received a refund of state or local income taxes
(2) individuals who owed the alternative minimum tax (AMT)in the prior year, or
(3) Individuals who could be claimed as a dependent by someone else in the prior year.
Only those individuals who itemized deductions and received a federal income tax benefit for deducting their state or local income taxes have to include their state/local tax refunds in income on their federal income tax return. None of the refund is taxable if these individuals itemized deductions and included the state sales tax instead of the state income tax withheld as part of their itemized deductions.