Exemptions: What They Are and How They Affect Your Taxes

Tax exemptions, exempt workers and tax-exempt status mean different things. They can also mean different things for your tax bill.
Income Taxes, Personal Taxes, Taxes
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What Are Tax Exemptions and How Do They Work?

A tax exemption is one way to lower your tax bill, but it’s not the only exemption that affects your taxes. Knowing the difference among tax exemptions, exempt workers and tax-exempt status will help you optimize your tax situation. Here’s how those terms tend to appear in the wild and how you can make “exempt” work for you.

Confusing term No. 1: Tax exemption

Tax exemptions aren’t the same as tax deductions, but they have the same end game: They cut your tax bill. Generally, tax deductions are expenses you’ve incurred that whittle down the amount of your income that’s subject to tax. Tax exemptions whittle down what counts as income in the first place; that is, exemptions come right off the top.

There are two kinds of income tax exemptions: 

  • Personal exemptions are for you and your spouse
  • Dependency exemptions are typically for your children or other people you support

In 2017, the personal and dependency exemption is $4,050. If you’re single, that means you get to lop $4,050 off your income by claiming a personal exemption for yourself. If you’re filing a joint return, you and your spouse each get to take a personal exemption. There are special rules if you’re married but file separately.

You also get an exemption for each of your dependents. If you’re married and have two children, you could claim $16,200 in exemptions for 2017. See IRS Publication 501 to find out who counts as a dependent; your tax software should also walk you through the determination.

You claim exemptions on your Form 1040, 1040A or 1040EZ each year. But here’s the catch: There’s an income limit. In 2017, the exemptions start phasing out when your adjusted gross income hits $313,800 if you’re filing jointly or $261,500 if you’re single. You lose the exemptions completely once your AGI hits $436,300 for joint filers or $384,000 for singles.

Exemption phase-outs

Filing statusPersonal exemption begins phasing out at AGI of…Personal exemption disappears for AGIs above…
Single$261,500$384,000
Married filing jointly$313,800$436,300
Head of household$287,650$410,150
Married filing separately$156,900$218,150

Confusing term No. 2: Exempt worker

This phrase can have two meanings.

1. You’re exempt from withholding

In this situation, you’re electing not to have federal income tax withheld from your paychecks. Social Security and Medicare taxes will still come out of your check, though.

This is an important decision because income tax is a pay-as-you-earn affair. The minute you get income, the IRS wants its cut. That’s why the W-4 exists; it’s a form you give to your employer, instructing it how much tax to withhold from each paycheck and send to the IRS on your behalf. At the end of the year, your employer sends you a W-2 showing, among other things, how much it withheld for you that year.

Income tax is a pay-as-you-earn affair. The minute you get income, the IRS wants its cut.

Typically, you become exempt from withholding only if two things are true:

2. You’re exempt from minimum wage and overtime rules

The Fair Labor Standards Act requires that most workers get paid at least minimum wage and overtime. However, some people in executive, administrative, professional and outside sales jobs are exempt from those rules.

The Labor Department uses a few tests to determine whether an employee is exempt from the minimum wage and overtime rules. They generally have to do with pay and job duties. Learn more on the department’s website.

Confusing term No. 3: Tax-exempt status

This term typically refers to charities that are recognized by the IRS. They’re exempt from federal taxation, and donations made to them are typically tax-deductible.

You can cut your tax bill by making donations to tax-exempt organizations, but be sure that the organization is indeed tax-exempt. You can do that by visiting the IRS’s Exempt Organizations Select Check tool.

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