Credit Card Rewards: A Non-Taxable Benefit
When tax season comes around and you start sifting through our different sources of income to report, you might be wondering if you need to report your cash back rewards as part of your ordinary income. If reading this article is the first time you have ever considered it as a possible income source and you've overlooked this detail in past tax returns, don't worry—the IRS is not going to be looking for you. Thankfully, credit card rewards are non-taxable! So you can enjoy the rewards without having to deal with the headache of reporting on it. In this article, I am going to deep dive into the rules that make this possible.
The Non-Taxable Nature of Credit Card Rewards
Credit card rewards are typically categorized by the IRS as discounts rather than income. Essentially, when you receive 2% cash back on purchases, the IRS views this as a 2% discount on what you've spent, not as additional income earned. This distinction is crucial because it means that the rewards do not increase your taxable income, providing a clean financial benefit without affecting your tax bracket.
Eligible Types of Credit Card Rewards
- Cash Back: Directly reduces the cost of purchases by returning a percentage of the amount spent.
- Points: Accumulated points can be redeemed for goods, services, travel, or even converted into cash.
- Miles: Often used for travel-related purchases, such as airfare or hotel bookings, offering significant savings on travel expenses.
- Welcome Bonuses: Promotional rewards given to new cardholders as an incentive for signing up and spending a certain amount on the card within the first few months. These bonuses can be in the form of cash back, points, or miles and are designed to attract new customers with a substantial initial reward.
Maximizing and Compounding Credit Card Rewards
For some of my cash back cards, I like to use the reward as a savings/investment funding source. This is because since it's non-taxable, it makes it easy for me to utilize the full sum without having to worry about saving part for taxes.
To illustrate the power of maximizing and reinvesting credit card rewards, consider a hypothetical scenario where you spend $1,000 per month on a credit card offering 2% cash back. This scenario assumes that you reinvest your cash back into a conservative investment account yielding an average annual return of 4% (keep in mind the average return of S&P500 is typically 7%+). Here’s how your rewards can potentially grow over time due to the compounding effect:
| Year | Monthly Spend | Annual Cash Back | Investment Growth | Total Value at Year End |
|---|---|---|---|---|
| 1 | $1,000 | $240 | $5 | $245 |
| 5 | $1,000 | $240 per year | $62 | $1,382 |
| 10 | $1,000 | $240 per year | $167 | $3,307 |
| 20 | $1,000 | $240 per year | $528 | $8,232 |
Note: This table simplifies the calculation by assuming the cash back is received in a lump sum at the end of each year and immediately invested. In actuality, you can invest monthly when rewards are typically rewarded at the end of the billing cycle.
Strategic Considerations for Credit Card Rewards
When strategically used, credit card rewards can serve as a small but steady investment stream. Here are some key considerations:
- Reward Optimization: Choose cards that offer the highest returns on the categories where you spend the most.
- Fee Management: Ensure that any fees associated with the credit card do not outweigh the benefits received from rewards.
- Payment Discipline: Pay off balances in full each month to avoid interest charges that could negate the benefits of rewards. This typically means paying off the statement balance each billing cycle (do not just pay the minimum payment due!)
Conclusion
Credit card rewards represent a unique financial tool that leverages everyday spending into potential savings and investment gains. By understanding the tax-free nature of these rewards and employing a strategy that maximizes their return, you can enhance your financial portfolios subtly but significantly. When it comes to investing, please consult with an actual financial advisor (I am not a financial advisor). The key is to use these rewards judiciously and reinvest them to harness the power of compounding.