Being tax exempt or having a tax exemption seems like a way to lower your tax bill, but it can get you in trouble if you don’t understand the difference between tax exemptions, exempt workers and tax-exempt status. Here’s how those terms tend to appear in the wild and how you can make “exempt” work for you.
What is a tax exemption?
A tax exemption is the right to exclude certain amounts of income or activities from taxation. A few years ago, taxpayers were able to exclude $4,050 or more off their income by claiming personal exemptions. Personal exemptions no longer exist.
What does it mean to be tax exempt?
Tax-exempt typically refers to people or charities whose income or business is free from federal, state or local tax.
- Tax-exempt charities are 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 Tax Exempt Organization search tool.
Who is tax exempt?
“Tax exempt” can have two meanings for individuals.
1. You’re exempt from withholding tax
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.
Typically, you can be exempt from withholding tax only if two things are true:
- You got a refund of all your federal income tax withheld last year because you had no tax liability
- You expect the same thing to happen this year
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.
The difference between tax exemptions, tax deductions and tax credits
Tax exemptions aren’t the same as tax deductions or tax credits.
- Tax exemptions whittle down what counts as income in the first place; that is, exemptions come right off the top. Personal exemptions no longer exist.
- Tax deductions generally are expenses you’ve incurred that whittle down the amount of your income that’s subject to tax.
- Tax credits are dollar-for-dollar reductions in your tax bill.
There used to be two kinds of income tax exemptions — personal exemptions for you and your spouse, and dependency exemptions typically for your children or other people you support — but these went away with the new tax rules that took effect in 2018.
Here’s how it used to work. A few years ago, the personal and dependency exemption was $4,050. If you were single, that meant you got to lop $4,050 off your income by claiming a personal exemption for yourself. If you were filing a joint return, you and your spouse each got to take a personal exemption. There were special rules if you’re married but file separately. You also got an exemption for each of your dependents. But again, these tax exemptions have gone away.