Fact checked by Ryan Eichler
An asset is any resource with economic value that provides a future benefit to its holder. Assets differ from income in that income represents money being received, whereas an asset is something a person already owns, such as money or property.
The Internal Revenue Service (IRS) considers most income taxable, though some are tax-exempt. The IRS clearly outlines which types of income are taxable and which are not in the Internal Revenue Code Internal Revenue Code (IRC).
Key Takeaways
- An asset is any resource with economic value that offers future benefit.
- Income refers to money being received, while an asset is money or property already in your possession.
- The IRS generally taxes income, with exceptions for specific types of tax-exempt income.
- Many taxpayers use financial planning strategies that can lower their overall income tax liability.
Taxable Income vs. Tax-Exempt Income
Taxable income includes wages, salaries, bonuses, and tips, and unearned income. Unearned income is money received from investments or other non-employment sources. Examples include interest from savings accounts, bond interest, alimony, and dividends from stock.
In some cases, tax refunds may also be considered taxable income, especially if you previously deducted state or local taxes from your federal return. If you did, any state tax refund you receive could be taxable. The IRS requires taxpayers in this situation to report their refund on Schedule A of Form 1040. This rule is in place to prevent taxpayers from claiming a deduction for their state income taxes and then, later, also receiving a tax-free refund.
Certain types of income are tax-exempt under the IRC. These include:
- Inheritances
- Child support payments
- Welfare payments
- Manufacturer rebates
- Adoption expense reimbursements
Additionally, gains in tax-deferred accounts are protected from taxation, though they may be taxed later (e.g., when funds are withdrawn). These accounts include individual retirement accounts (IRAs), 401(k) plans, and tax-deferred annuities. However, violating certain conditions (such as early withdrawals) may subject the funds to taxes.
Gains in tax-deferred accounts may be taxed if special conditions are violated (such as an early withdrawal of the monies or illegal usage of the funds in the account).
Financial Planning Strategies That Reduce Taxable Income
Many taxpayers use strategies to minimize taxable income and lower their overall total tax liability. A common strategy involves using tax-deferred accounts to delay taxes until retirement. These accounts allow your investments to grow without being taxed until withdrawal.
Tax-friendly investments, such as index funds, tax-efficient stocks, and volatile stocks, are best held in taxable accounts. Conversely, taxable bonds, real estate investment trusts (REITs), and mutual funds should ideally be kept in tax-deferred accounts to minimize the tax burden.
Take Advantage of Deductions and Credits to Reduce Taxable Income
Other legal ways of reducing your taxable assets are to take advantage of all available tax deductions and tax credits. A tax deduction reduces the income you’re taxed on, while a tax credit actually cuts your tax bill directly.
Tax Deductions
Tax Deductions reduce your taxable income, lowering the amount of income subject to taxation. For example, if you qualify for a deduction, you subtract it from your total income. The more deductions you claim, the less tax you’ll owe. The lower your taxable income, the lower your tax bill.
There are two options for claiming a tax deduction. You can either claim the standard deduction or itemize your deductions. Choosing to itemize deductions or opt for the standard deduction will impact a taxpayer’s total liability, so it is worthwhile to compare tax liability under both options if you’re uncertain.
The standard deduction lowers your taxable income by a fixed amount. If the standard deduction that a taxpayer qualifies for (based on their age, income, and filing status) is greater than the sum of the itemized deductions they qualify for, they are better off taking the standard deduction.
If the standard deduction that a taxpayer qualifies for (based on their age, income, and filing status) is greater than the sum of the itemized deductions they qualify for, they are better off taking the standard deduction.
Tax Credits
Tax Credits directly reduce your tax bill on a dollar-for-dollar basis. This means that if you’re eligible for a $1,000 tax credit, your tax bill will be reduced by exactly $1,000, regardless of your income.
Tax credits can even result in a refund, depending on the circumstances. Some of the most common tax credits that taxpayers are eligible for include the American Opportunity Tax Credit (AOTC), Child Tax Credit, Adoption Credit, and the Lifetime Learning Credit.
If your tax liability is reduced to zero and the credit exceeds your total tax owed, the IRS may issue you a refund for the remaining amount. This feature is called a refundable credit. There are two types of tax credits, nonrefundable and refundable.
A nonrefundable tax credit can reduce your tax liability to zero, but it cannot result in a refund. If the amount of the credit exceeds the taxes you owe, the excess credit is simply lost. On the other hand, a refundable tax credit, can result in a refund if the credit exceeds your tax liability. This can be especially helpful for lower-income earners or those with children, as it can provide them with a cash boost even if they don’t owe any taxes.
What Types of Income Are Considered Taxable?
Taxable income includes wages, salaries, bonuses, tips, interest income, dividends, and capital gains from the sale of assets. It also includes unearned income such as alimony, rental income, and certain types of retirement account withdrawals. The IRS generally taxes most forms of income, with specific exceptions outlined in the Internal Revenue Code.
Are There Any Exemptions for Tax on Inheritance or Gifts?
Yes, inheritances and gifts are generally not taxed as income, but they may be subject to estate or gift taxes depending on the amount. The IRS allows an exemption limit for gifts and estates above which taxes may apply. For example, the federal estate tax exemption in 2025 is $13.9 million, meaning estates valued under this amount are exempt from federal estate taxes.
How Can Tax-Deferred Accounts Reduce My Taxable Income?
Tax-deferred accounts, like 401(k)s and IRAs, allow you to contribute money before taxes are taken out, reducing your taxable income for the year of the contribution. Earnings within these accounts grow tax-free until withdrawal, typically in retirement. This allows you to delay paying taxes on the growth of your investments until you start taking distributions.
The Bottom Line
Understanding which assets are taxable and which are tax-exempt is essential for effective financial planning. By leveraging tax-deferred accounts and utilizing available deductions and credits, you can reduce your taxable income and overall tax liability. Thoughtful investment choices and planning can help you retain more of your income and assets for the future.