The IRS offers the following list of items that do not have to be included as taxable income:

Adoption expense reimbursements for qualifying expenses
Child support payments
Gifts, bequests and inheritances
Workers’ compensation benefits (some exceptions may apply; see Publication 525, Taxable and Nontaxable Income)
Meals and lodging for the convenience of your employer
Compensatory damages awarded for physical injury or physical sickness
Welfare benefits
Cash rebates from a dealer or manufacturer
Some income may be taxable under certain circumstances, but not taxable in other situations. Examples of items that may or may not be included in your taxable income are:

Life insurance If you surrender a life insurance policy for cash, you must include in income any proceeds that are more than the cost of the life insurance policy. Life insurance proceeds, which were paid to you because of the insured person’s death, are generally not taxable unless the policy was turned over to you for a price.
Scholarship or fellowship grant If you are a candidate for a degree, you can exclude from income amounts you receive as a qualified scholarship or fellowship. Amounts used for room and board do not qualify for the exclusion.
Non-cash income Taxable income may be in a form other than cash. One example of this is bartering, which is an exchange of property or services. The fair market value of goods and services exchanged is fully taxable and must be included as income on Form 1040 of both parties.
All other items—including income such as wages, salaries, tips and unemployment compensation — are fully taxable and must be included in your income unless it is specifically excluded by law.

These examples are not all-inclusive. For more information, see Publication 525, Taxable and Nontaxable Income

Why should this be? Well, when an employee fills out a Form W-4 (the official name) and stipulates the amount of allowances to be claimed, he or she is basing the claim in large part on the expected tax filing situation for the year – namely, how much he or she is expecting to earn.

Every allowance reduces the amount of federal income tax withheld, which in turn lowers the tax refund that may be due. In fact, one’s tax liability may possibly even be raised!

No interest is paid by the government in instances of over-withholding, but if, due to those allowances claimed, under-withholding results, the employee will need to pay penalties at a certain point. The situation is rendered all the more difficult for some because of the fact that it’s possible to claim different numbers of allowances between a W-4 Form and a 1040 series form.

Another potential source of misunderstanding entails the fact that the W-4 Form doesn’t deal with seasonal employment. Just a casual layman’s perusal of tax policies at the level of the end-user shows how really esoteric tax laws can be! When even simple matters like reporting income and claiming allowances can be subject to such nuance and variability, one really does wonder just to whom these laws are supposed to benefit.

Yet believe it or not, though wider tax policies at the macro level may be open to debate, many of the little nitty-gritty details such as those layed out here were actually intended to help rather than hinder or even hurt.