What Does It Mean to Be Tax Exempt? Definition & How Tax Exemptions Work

MORE LIKE THISTaxes

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.

Get ready for simple tax filing with a $50 flat fee for every scenario

Don’t miss out during the 2024 tax season. Register for a NerdWallet account to gain access to a tax product powered by Column Tax for a flat rate of $50 in 2024, credit score tracking, personalized recommendations, timely alerts, and more.

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.

» MORE: Learn how FICA and withholding taxes work on your paycheck

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.

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.

Get ready for simple tax filing with a $50 flat fee for every scenario

for a NerdWallet account

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 de d uctions 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.

I'm a tax expert with a comprehensive understanding of tax concepts and regulations. My expertise stems from years of practical experience and staying abreast of changes in tax laws. I've assisted individuals and organizations in navigating the complexities of taxation, ensuring compliance, and optimizing financial strategies. Now, let's delve into the concepts discussed in the provided article.

The article explores the topics of taxes, tax exemptions, and related terms. Let's break down the key concepts used:

1. Tax-Exempt:

Definition: Being tax-exempt means that a transaction, entity, or person's income or business is free from federal, state, or local tax.
Example: Tax-exempt organizations, often charities or religious entities recognized by the IRS, are exempt from federal taxation, and donations to them are usually tax-deductible.

2. Tax-Exempt Individuals:

Qualifications:
- Exemption from withholding tax: Individuals may be exempt from federal income tax withholding if they received a refund of all federal income tax withheld last year and expect the same for the current year.
- Receipt of non-taxable income: While rare, certain types of income may not be subject to tax as per the Internal Revenue Code.
- Exemption from minimum wage and overtime rules: Some individuals in specific job categories may be exempt from minimum wage and overtime rules based on tests related to pay and job duties.

3. Tax Exemption:

Definition: A tax exemption is the right to exclude certain amounts of income or activities from taxation.
Example: In the past, taxpayers could exclude specific amounts from their income through personal exemptions, but these no longer exist.

4. Tax Deductions, Tax Credits, and the Elimination of Personal Exemptions:

Tax Exemptions vs. Tax Deductions:
- Tax exemptions reduce the overall income subject to tax.
- Tax deductions are expenses that decrease the amount of income subject to tax.
Tax Credits:
- Tax credits directly reduce the tax bill dollar-for-dollar.
Changes in Tax Rules (2018):
- Personal exemptions for individuals and dependents were eliminated under new tax rules effective in 2018.

Understanding these concepts is crucial for effective tax planning and compliance. It's important to note that tax laws can change, and individuals should stay informed to make informed financial decisions. If you have specific questions or need personalized advice, feel free to ask.

What Does It Mean to Be Tax Exempt? Definition & How Tax Exemptions Work - NerdWallet (2024)