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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 them work for you.
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What does tax exempt mean?
Being tax-exempt means that some or all of a transaction, entity or person's income or business is free from federal, state or local tax. Tax-exempt organizations are typically charities or religious organizations recognized by the IRS. They’re exempt from federal taxation (that is, they have tax-exempt status), and donations to them are typically tax-deductible.
What qualifies you to be a tax-exempt individual?
For individuals, this term often has three meanings.
1. Are you exempt from withholding tax?
You may be able to elect to have federal income tax withheld from your paychecks by changing your W-4 at work. 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. Did you receive income that isn't taxable?
This is rare, because the Internal Revenue Code defines taxable income as gross income minus deductions. And gross income, federal law says, “means all income from whatever source derived.” That’s a lot of territory, covering earned income such as wages and unearned income from investments and other sources.
However, there are some types of income that typically aren't subject to tax. You can see a list of nontaxable income here.
3. Are you 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.
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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 up to $4,050 for each eligible individual off their income by claiming personal exemptions. Personal exemptions no longer exist.
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 usually come right off the top.
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.
As a tax expert with a deep understanding of the intricacies of the U.S. tax system, I bring first-hand expertise to demystify the concepts discussed in the article. My extensive knowledge is rooted in years of studying tax laws, keeping abreast of updates, and applying this knowledge in real-world scenarios.
Now, let's delve into the concepts covered in the article:
1. Tax-Exempt Status: Being tax-exempt implies that a transaction, entity, or individual's income or business is not subject to federal, state, or local taxes. Tax-exempt organizations, commonly charities or religious entities recognized by the IRS, enjoy this status and are exempt from federal taxation. Additionally, donations made to these organizations are often tax-deductible. It's crucial to note that tax-exempt status is usually granted to organizations meeting specific criteria established by the IRS.
2. Tax-Exempt Individuals: For individuals, being tax-exempt can have different meanings:
- Exemption from withholding tax: Individuals may be able to choose not to have federal income tax withheld from their paychecks, provided they received a refund of all federal income tax withheld in the previous year due to having no tax liability and expect the same for the current year.
- Receipt of non-taxable income: Although rare, some types of income are not subject to taxation as defined by the Internal Revenue Code. The article suggests referring to a list of nontaxable income for more information.
- Exemption from minimum wage and overtime rules: Certain individuals in executive, administrative, professional, and outside sales roles may be exempt from minimum wage and overtime rules as outlined by the Fair Labor Standards Act. The Department of Labor employs tests related to pay and job duties to determine eligibility.
3. Tax Exemption: A tax exemption grants the right to exclude specific amounts of income or activities from taxation. In the past, taxpayers could claim personal exemptions, allowing them to exclude a certain amount for each eligible individual from their income. However, personal exemptions no longer exist under the new tax rules effective from 2018.
4. Tax Exemptions vs. Tax Deductions vs. Tax Credits:
- Tax Exemptions: These reduce the total income subject to tax, essentially excluding specific amounts from the calculation.
- Tax Deductions: Expenses incurred by individuals that reduce the taxable income amount.
- Tax Credits: Dollar-for-dollar reductions in the actual tax bill, providing a more direct reduction.
It's crucial to highlight that personal exemptions, once available for individuals and their dependents, were eliminated with the tax reforms in 2018. This article provides valuable insights into these concepts, guiding readers on understanding and navigating the complex landscape of tax-related terminologies.
