The best income to receive tax-wise is tax free. And while it may seem surprising, there are many kinds of tax-free income available. Here are a dozen kinds of income on which you need never pay tax…

1. New tax-free capital gains and dividends. Starting in 2008, capital gains and qualified dividends are tax free to people in the 10% and 15% tax brackets — which cover taxable income up to $65,150 on a joint return and $32,550 on a single return. Total income can be larger when taking personal exemptions and standard or itemized deductions into account.

Alternative: If your income is too high for you to qualify to take such income tax free, consider making gifts of capital gains and dividend-paying assets to lower-bracket family members who do qualify.

2. Roth IRA and Roth 401(k) earnings. Contributions to these retirement savings accounts aren’t deductible, but all investment returns earned in them and distributions from them can qualify to be totally tax free.

Long-term planning: There is a real risk that tax rates will increase in coming years due to large looming budget shortfalls and surging costs of Medicare and Social Security.

If tax rates do rise, tax-free income from Roth IRAs and Roth 401(k)s will become even more valuable compared with retirement income taxed at ordinary rates when received from traditional IRAs and other kinds of retirement plans.

3. Interest-free loans. A parent might want to make a loan to a child. Loan proceeds are tax free to the recipient, and loans given on interest-free terms effectively provide tax-free income to the recipient by saving the interest cost that would normally be owed when taking out a bank loan of such an amount.

No adverse tax consequences result from an interest-free loan if all such loans made by the lender to the recipient do not exceed…

$10,000, and the recipient does not invest the loan amount in income-producing assets (such as an interest-paying savings account, bonds, or dividend-paying stocks).

$100,000, and the recipient’s net investment income does not exceed $1,000 in one year.

The recipient can obtain a valuable return from the loan proceeds by using them to start a business, buy a home or other asset, pay for education, etc.

Caution: For loans larger than the above amounts, and when the rules aren’t met for loans of the above sizes, interest may be “imputed” on a loan — meaning that tax-wise, the loan is treated as if interest is paid on it even though none actually is. Tax consequence: The lender has taxable interest income.

4. Children’s earned income. A dependent child can receive up to $5,450 of income earned from a job tax free in 2008 — protected from tax by the child’s standard deduction. Even better…

If the child places a like amount in a Roth IRA, he/she can earn compounding tax-free investment income on it for life.

If the child’s salary is paid by a parent’s business, the business can deduct the salary — making that much of its income tax free to the family. If the child is under age 18 and the parent’s business is unincorporated, no Social Security tax is due on the child’s wages.

5. Children’s investment income. The so-called “kiddie tax” applies generally to the investment income of children under age 19, and dependent children under age 24 who are full-time students, which is taxed at their parents’ tax rate.

But the first $900 of a child’s investment income is exempt from any tax in 2008 (and the next $900 will be taxed to the child at the child’s rate). And a child may have a significant amount of investments to “use up” this $900.

Example: If a child invests in bonds paying 5% interest, it would take $18,000 of bonds to pay $900 interest. So, despite the kiddie tax, a minor child can still own $18,000 of such bonds tax free.

6. Perpetually tax-deferred gain. Capital gains tax on appreciated properties, such as investment or business real estate, can be deferred by swapping one property for a replacement in a “like-kind exchange” instead of selling the property for cash. Taxable gain is deferred until the replacement property is sold — but that property also can be swapped in a tax-deferred exchange, and so on, indefinitely.

In the meantime, tax-free cash can be obtained from the appreciating properties by borrowing against them.

The requirements to make a like-kind exchange are technical, so for the details, see IRS Publication 544, Sales and Other Dispositions of Assets.

7. Education savings. Contributions to a state-sponsored “Section 529” college savings plan and/or to a Coverdell Education Savings Account can earn investment returns that are tax free when used to pay education costs. Also, up to $5,250 received from an employer’s qualified education assistance plan can be taken tax free when used to pay for the employee’s education.

For details about these and several other related tax benefits, see IRS Publication 970, Tax Benefits for Education.

8. Home sales. Up to $250,000 of gain can be taken tax free on the sale of a home when you’ve owned it and used it as a primary residence for two of the prior five years. The limit is $500,000 on a joint return.

9. Municipal bond interest. This is generally tax exempt from federal income tax — and may be exempt from state and local income tax as well.

Caution: Certain municipal bonds, known as “private activity bonds” (because they finance nongovernmental functions, such as construction of sports stadiums), pay interest that is taxable under the alternative minimum tax (AMT). If you may be subject to the AMT, consult your tax and/or investment adviser.

10. Gifts. These are tax free to recipients. Gift makers incur no tax cost on gifts up to $12,000 per recipient each year ($24,000 when gifts are made jointly by a married couple). In addition, gift makers have a $1 million lifetime gift tax exempt amount.

Gifts can reduce income tax by shifting income-producing assets to family members in lower tax brackets, and reduce future estate tax by shifting assets out of an estate.

11. Bequests. These are tax free to recipients, and all taxable gain on bequeathed assets is eliminated at the owner’s death through “stepped-up basis.” This resets the basis of inherited property at its market value as of the date of the owner’s death.

Example: A parent owns appreciated investment real estate that would produce a $1 million taxable gain if he sold it. If he instead bequeaths the property to his children, they can sell it tax free for its value at the date of his death.

12. Employer provided tax-free fringe benefits and “perks.” Employers can provide a wide range of tax-free fringe benefits that effectively provide employees with tax-free income.

Examples: Employer matching contributions to 401(k) savings… group term life insurance coverage up to $50,000… disability insurance… flexible spending accounts into which employees can deposit a pretax portion of salary to pay for medical or dependent-care costs… employee discounts on products or services… free parking worth up to $220 per month, and transit passes worth up to $115 per month… and more.

Check with your employer’s benefits manager to be sure that you aren’t missing out on any tax-free pay.

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