Hot Sources of Tax-Free Income

You don't need fancy investment strategies or risky tax shelters to get tax-free income. Here are two-dozen straightforward ways...

* Home rentals of up to 14 days are tax free. If you rent out your home or second home for no more than 14 days, you don't have to report to the IRS the rent you receive.

Tactic: If a popular tournament, race, or other attraction is scheduled near you, consider renting your home to an attendee and using the money you receive tax free to pay for your own vacation.
* Roth IRAs allow withdrawals after
age 59 1/2 that are totally tax-and-penalty free. A Roth IRA that's set up early in life will earn compound investment returns for decades and will ultimately provide a tremendous tax-free payoff.
* Gifts of all kinds are income tax free to the recipient. They can reduce or eliminate income taxes that a family is currently paying, too, when income-producing property is given by a high-tax-bracket taxpayer to family members in low tax brackets, such as children over age 13.

Caution: Investment income above $1,700 of children under age 14 is taxed at their parents' top rate.

Gifts of up to $12,000 each can be made to as many recipients as you wish, in 2006 using the annual gift tax exclusion. The limit is $24,000 for gifts made jointly with a spouse.
* Expense reimbursements from an employer are tax free. Negotiate for reimbursement from your employer if you currently incur out-of-pocket business costs for items such as publications, professional dues, meals, driving, purchases of supplies or equipment, etc.

You and your employer can both benefit by converting salary to reimbursements. You'll then pay your expenses with pretax rather than after-tax dollars -- and your employer won't owe employment taxes on the reimbursement amounts as it does on salary.
* Flexible spending accounts (FSAs) for medical and dependent-care expenses let you avoid owing tax on a portion of your pay that you set aside to cover these expenses. If your employer offers FSAs through a "cafeteria" benefit plan, make full use of them.
* Children's salaries paid by a family business effectively let the business take a portion of its income tax free. The business gets to deduct the salary payments at its high tax rate, while a child can earn up to $5,150 tax free in 2006 -- plus another $7,550 taxable at only 10%, and additional income over $7,550 to $30,650 taxable at only 15%.

When a child under age 18 is paid by a parent's unincorporated business, the payments are also free of Social Security and Medicare taxes. And the Tax Court has allowed deductions for reasonable wages paid to children as young as seven.
* More Social Security benefits may be taken tax free if you invest in appreciating assets, Series EE and I savings bonds, and cash-value life insurance. The increase in the value of such investments adds to your wealth but is excluded from your current income until cashed in -- so it won't push your income over the threshold that makes your Social Security taxable.
* Gain on the sale of a home is tax free up to $250,000 ($500,000 on a joint return) when you have used the home as your main residence for at least two of the prior five years. You can make such a tax-free sale once every two years.

If you own other residences (such as vacation or investment properties) in addition to your principal residence, you can move into them for two years at a time to take tax-free gain on them, too, when selling them.
* Life insurance proceeds are tax free to the beneficiary. They also escape estate tax when the insured individual does not retain "incidents of ownership" in the policy. Achieve this by having the policy owned by another party or a life insurance trust.

Tactic: Instead of leaving taxable bequests of other assets, consider using tax-free life insurance to fund bequests.
* Borrowed funds are tax free -- even if you don't have to repay them during your lifetime. Examples...

o Borrowing against the appreciating cash value of a life insurance policy, with the loan to be repaid ultimately from the policy proceeds.
o A reverse mortgage on a house that provides the home owner with a stream of income, which ultimately will be repaid from his/her estate.
* Frequent-flier miles continue to go untaxed by the IRS -- and the IRS recently stated it will not try to tax them in the future without giving advance warning to the public.
* Capital gain property held until death becomes income tax free to heirs. Currently, at death, the tax basis in the property is stepped up to market value -- making all appreciation in the property's value up to that date tax free to those who inherit it.
* Like-kind exchanges allow you to trade an appreciated property for a similar property -- such as one real estate property for another -- while deferring the realization of taxable gain until the second property is sold.

But that property, too, can be disposed of through another like-kind exchange, and so on, deferring taxation on gain indefinitely.
* Parking paid for by an employer is tax free up to $205 per month. So is up to $105 per month for transit passes or car-pooling expenses.
* Tuition reimbursement of up to $5,250 per year can be provided tax free by an employer to an employee under an educational assistance program.
* Interest-free loans can be a source of cash at no tax cost to either lender or borrower, up to certain limits. Loans of up to $10,000 have no adverse tax consequences.

Loans of more than $10,000 and up to $100,000 are treated as if interest is paid on them (interest is "imputed," so taxable interest income results to the lender) but only to the extent that the borrower has investment income.

Thus, interest-free loans are tax free if the borrower has no investment income.
* Long-term health-care insurance provides proceeds that are tax free. In addition, premiums on these policies are deductible in an amount that varies by age (from $280 at age 40 or younger to $3,530 at age 71 or older). Premiums paid for by an employer may be a tax-free benefit.
* Government bonds are tax favored. State and municipal bonds are generally free of federal income tax, and may be free of state tax as well, providing totally tax-free income. Federal bonds are exempt from state taxes.
* Coverdell education savings accounts let investment returns earned in them be used tax free to pay not only college costs but also elementary and high school costs, as well as for books, supplies, after-school programs, tuition, tutoring, and even home computers.
* Section 529 college savings plans let investment earnings be used tax free for education costs. In contrast to Coverdell accounts, much more can be contributed to a 529 plan, but 529 funds can be used only for college costs.
* Scholarship and fellowship grants are tax free when used to pay for tuition and course-related fees, books, equipment, and supplies.
* Accelerated death benefits (viatical settlements) paid on a life insurance policy to a terminally ill insured individual before he/she dies are tax free.
* Adoption expenses. Employers can provide up to $10,960 in tax-free assistance to employees who are adopting children to help cover adoption expenses.
* Employer-provided insurance, such as health and accident insurance, and up to $50,000 in group term life insurance, can be provided tax free to employees while being deducted by the employer who provides it.