Medicaid waiver payments are tax-free: how to report (Notice 2014-7)

For a family caregiver, the work comes first and the paperwork comes much later. A parent caring for a disabled child at home, or an adult son or daughter caring for an aging parent, signs up through a state Medicaid waiver program, does the daily work of feeding and bathing and lifting, and is paid a modest amount for it. Then, in late January, a W-2 arrives — and the income is sitting right there in box 1, the box for taxable wages. The natural question, asked at thousands of kitchen tables every winter, is the obvious one: do I owe tax on money I was paid to care for my own child?

The short answer: in most cases, no. Under IRS Notice 2014-7, these Medicaid waiver payments are treated as “difficulty of care” payments that you can exclude from gross income, provided you live in the same home as the person you are caring for. The catch is not whether the money is taxable — it usually is not — but how you report it. The reporting path changed, and the old instructions you will still find on forums, telling you to enter a negative on “line 21,” are out of date. The current path runs through Form 1040 line 1a, line 1d, and a negative entry on Schedule 1 line 8s.

What Notice 2014-7 actually excludes

Notice 2014-7 is the IRS’s answer to a long-standing question about state Medicaid Home and Community-Based Services waiver programs. The IRS decided to treat certain payments under those programs as “difficulty of care” payments, which are excludable from gross income under Internal Revenue Code section 131. In plain terms, the money you are paid to provide care can be left out of your taxable income.

The decisive condition is the living arrangement: the care provider and the disabled care recipient must live in the same home. A parent caring for a disabled child under the family roof qualifies; so does an adult caring for a parent who lives with them. This is why the exclusion so commonly covers In-Home Supportive Services, or IHSS, in California, and similar programs run by other states — the structure of those programs typically has the caregiver and the recipient sharing a residence. If you live with the person you care for, you are squarely in the territory Notice 2014-7 covers.

The reporting mechanic that changed — W-2 case, line by line

Here is where families go wrong, because the form instructions evolved. For tax years 2024 and 2025, when the payments come on a W-2, the reporting works in three moves:

What you have	Where it goes
W-2 box 1 (wages)	Form 1040 line 1a
W-2 box 12, code II	Form 1040 line 1d
Total nontaxable Medicaid waiver payments	Schedule 1 line 8s, as a negative

First, report the W-2 box 1 amount on Form 1040 line 1a, the line for wages from your W-2. Second, report the box 12 code II amount — the figure many agencies now use to flag these excludable payments — on Form 1040 line 1d. Third, and this is the step that does the actual work, enter the total nontaxable Medicaid waiver payments on Schedule 1 line 8s as a negative number, written inside the preprinted parentheses on that line.

That negative is the exclusion. Because it is negative, it can pull Schedule 1 lines 8z, 9, and 10 into negative territory as well — and that is exactly what is supposed to happen. A negative subtotal flowing off Schedule 1 is not an error; it is the mechanism removing the payments from your taxable income.

The 1099-NEC / 1099-MISC case

Some caregivers are paid as independent contractors and receive a 1099-NEC or a 1099-MISC instead of a W-2. The exclusion still applies if you meet the same-home requirement, and the reporting is a slightly shorter version of the same idea: report the amount on Form 1040 line 1d, then enter the nontaxable amount as a negative on Schedule 1 line 8s. The line 8s negative again carries the exclusion, regardless of whether the payment arrived on a W-2 or a 1099.

Self-employment tax: you do not owe it

A caregiver paid on a 1099 might reasonably fear self-employment tax — the roughly 15.3% on top that ordinarily lands on a sole proprietor. It does not apply here. Notice 2014-7 difficulty-of-care payments are not self-employment income and are not subject to self-employment tax, even if you would otherwise be treated as a sole-proprietor caregiver. There is no Schedule SE to file on these payments. The exclusion that lifts them out of income tax also keeps them clear of the self-employment tax.

The Earned Income Credit choice

This is the part that surprises people, and it can be worth real money. Even though you exclude these payments from gross income, the rules let you make a separate choice for the refundable credits. For an open tax year, you may choose to include all of these payments in your earned income when you figure the Earned Income Credit or the Additional Child Tax Credit.

The counter-intuitive angle: those credits are built to reward earned income, and they phase in as earnings rise. A caregiver whose only money is excluded Medicaid waiver payments could otherwise show little or no earned income — and walk away from a credit they would have qualified for. By electing to count the payments as earned income for the credit calculation, some families end up with a larger Earned Income Credit or Additional Child Tax Credit than they would get by leaving the payments out. It is genuinely worth running the numbers both ways.

Where line 1z fits — and what the exclusion does to your AGI

A question that trips up caregivers reading their own return: after you follow the steps above, the wage figure is still sitting in line 1z of Form 1040, the line that totals everything on line 1 by adding lines 1a through 1h. People expect the exclusion to make that number disappear, and when it does not, they worry they have done something wrong. They have not. Line 1z is simply the sum of your wage lines, so the box 1 amount you entered on line 1a and the Medicaid waiver figure carried on line 1d both roll up into it. The exclusion is not taken there.

The money actually comes out one step downstream, on Schedule 1 line 8s, where you enter the total nontaxable Medicaid waiver payments as a negative. That negative flows through Schedule 1 into the additional-income total that lands back on Form 1040, and it is what pulls the payments out of your adjusted gross income. So the correct mental model is straightforward: line 1z shows the gross wages, and Schedule 1 line 8s is the valve that removes the excluded portion before adjusted gross income is computed. Seeing the wages in line 1z is expected and correct; what matters is that the negative on line 8s lowers the bottom-line AGI.

What the exclusion means for the FAFSA

That distinction matters beyond the tax return, because it controls how these payments are treated for financial aid. The current Free Application for Federal Student Aid (FAFSA), rebuilt under the FAFSA Simplification Act, no longer asks most families to hand-enter their income. Instead it imports federal tax information straight from the Internal Revenue Service through the Direct Data Exchange, and the income figure it works from is built on the adjusted gross income from your return. Because Notice 2014-7 payments are excluded from adjusted gross income by the negative on Schedule 1 line 8s, they are not part of the AGI the FAFSA pulls in — the same exclusion that keeps them off your taxable income keeps them out of the figure that drives the Student Aid Index. The simplified form also dropped many of the old untaxed-income questions that once added back amounts a tax return had excluded. Aid formulas can carry edge cases, so a family leaning on this for a particular award year should confirm the treatment with the school’s financial aid office, but the governing principle is simple: income excluded from your AGI does not reappear as income on an AGI-based FAFSA.

Fixing a prior year

If you reported these payments as taxable in an earlier year — paid the tax on income you could have excluded — you are not stuck with it. You can file Form 1040-X, the amended-return form, to claim the exclusion for any open year, as long as you are inside the refund window set by Internal Revenue Code section 6511 (generally three years from filing or two years from when you paid the tax). Amending lets a family recover tax it never actually owed on the care work it was already doing.

The work of caregiving is hard enough without losing money to a misread W-2. The income is usually tax-free; the only real task is reporting it on the right lines — 1a, 1d, and a negative on Schedule 1 line 8s — and, if it helps, choosing whether to count it toward the Earned Income Credit.

For the source rules, see the IRS FAQ on certain Medicaid waiver payments that may be excludable from income, IRS Notice 2014-7, and Internal Revenue Code section 131.