By Gayle Sato
Edited by Samuel MountjoyWhat Is a Tax Exemption and How Does It Work?
Quick Answer
A tax exemption lets you exclude certain types or portions of your income from being taxed. Although the personal exemption has been permanently eliminated, individual exemptions include insurance proceeds, Roth IRA distributions, veteran’s benefits and child support.
A tax exemption allows you to exclude part of your income when you calculate your income taxes. Tax exemptions are similar to tax deductions: They reduce your taxable income, which in turn can lower your tax bill.
Personal exemptions used to be a standard part of calculating individual federal income taxes. However, the Tax Cuts and Jobs Act of 2017 temporarily removed personal exemptions and dependent deductions in favor of larger standard deductions, and the One Big Beautiful Bill Act (OBBBA) of 2025 made those changes permanent.
That doesn't mean tax exemptions are a thing of the past, however. Here's how tax exemptions may still apply to you, your taxes and organizations with tax-exempt status.
What Does It Mean to Be Tax-Exempt?
Being tax-exempt means being excluded from regular taxation. A tax exemption may apply to income, transactions or organizations, and may exist under federal, state or local law.
Although a tax exemption functions almost the same as a tax deduction, they work slightly differently. A tax deduction subtracts a given amount from your taxable income, while tax-exempt income is never subject to tax in the first place. In either case, a tax deduction or tax exemption reduces the portion of your income that's taxable, and therefore reduces the amount of tax you'll pay.
Learn more: What Can You Deduct on Your Taxes?
What Is a Tax-Exempt Organization?
Tax-exempt organizations include charities and religious organizations that are not subject to federal taxes. These organizations typically benefit the community and operate without profit. If you donate money to an IRS-qualified tax-exempt organization, your donation may be tax deductible. However, if you work for a tax-exempt nonprofit, your wages are still taxable.
Tax Exemption vs. Deduction vs. Credit
Tax exemptions, tax deductions and tax credits all have the potential to save you money on your taxes. However, each type of tax break lowers your tax bill in a different way.
- Tax exemptions exclude certain types of income or revenue from your taxable income. For example, workers' compensation payments you receive for a work injury are exempt from federal tax, so you don't have to claim those payments on your tax return.
- Tax deductions allow you to reduce your gross income based on qualifying expenses you've incurred. Common tax deductions include student loan interest or charitable donations. You may also choose a standard deduction, which provides a relatively large deduction you can claim automatically, without itemizing and documenting individual tax deductions.
- Tax credits are applied to your final tax bill, reducing your tax liability dollar-for-dollar. If the highest portion of your income is taxed at the 22% rate, a $10,000 tax exemption or tax deduction would save you 22% of $10,000, or $2,200. A $10,000 tax credit saves you $10,000, subtracted directly from your tax bill.
Tax Exemption vs. Tax Deduction vs. Tax Credit
| What it reduces | Taxable income |
|---|---|
| How it applies | Excludes income from being taxed |
| Dollar-for-dollar impact | You save the exempted amount multiplied by your marginal tax rate. |
| Examples | Tax-exempt income includes workers' compensation payments, qualified distributions from a Roth IRA or veteran's benefits. |
| What it reduces | Taxable income |
|---|---|
| How it applies | Subtracts from your taxable income |
| Dollar-for-dollar impact | You save the deducted amount multiplied by your marginal tax rate. |
| Examples | Itemized deductions include mortgage interest and medical expenses. The standard deduction lets you automatically deduct a set portion of your taxable income. |
| What it reduces | Tax liability |
|---|---|
| How it applies | Reduces the amount of tax owed by applying a credit |
| Dollar-for-dollar impact | You save the full amount of the tax credit. If the tax credit is refundable, you may receive excess credit as a refund. |
| Examples | The child tax credit provides a credit of up to $2,200 per qualifying child in 2025. For the 2025 tax year, the earned income tax credit provides up to $649 in tax credits for single taxpayers and up to $8,046 for families with three or more dependents for low- and moderate-income taxpayers. |
Learn more: Tax Credit vs. Tax Deduction: What's the Difference?
Who Qualifies for a Tax Exemption?
As an individual, you may qualify for a tax exemption if you have certain types of tax-exempt income (see list below). You may also be exempt from having federal taxes withheld from your paycheck if you were not required to pay income taxes last year and don't expect to pay taxes in the current year.
Prior to the 2017 Tax Cuts and Jobs Act, nearly every taxpayer could claim a personal tax exemption. At that time, taxpayers were entitled to personal exemptions of up to $4,050 with additional exemptions for spouses and dependents. But, starting in 2018, these personal exemptions are no longer available. In their place, the federal government now allows taxpayers to claim larger standard deductions that reduce taxable income by $15,750 to $31,500 in 2025.
Other Possible Tax Exemptions
Although personal exemptions and deductions for dependents no longer exist, you may be able to claim other types of tax exemptions. Here are a few examples of tax-exempt income:
- Child support payments
- Employer-provided adoption assistance
- Dependent care benefits
- Payments for providing foster care
- Government disaster relief
- Life insurance proceeds
- Excluded capital gains from the sale of your home
- Interest earned on municipal bonds
- Qualified Roth IRA distributions
- Inheritances, gifts and some accelerated death benefits (within limitations)
- Academic scholarships used to pay for qualifying educational expenses
- Veterans' benefits
As this list shows, tax exemptions can be very specific. Working with a qualified tax advisor can help you find all of the tax exemptions—and other tax breaks—available to you. Alternatively, check out tax preparation software, which can help guide you through potential deductions, exemptions and credits to determine your best savings.
Frequently Asked Questions
The Bottom Line
Although learning the nuts and bolts of tax exemptions can require detailed detective work, knowing what's taxable—and what isn't—is key to saving money on your taxes. If you aren't sure whether your income is taxable or not, IRS Publication 525 provides a wealth of information, straight from the source.
What makes a good credit score?
Learn what it takes to achieve a good credit score. Review your FICO® Score for free and see what’s helping and hurting your score.
Get your FICO® ScoreNo credit card required
About the author
Gayle Sato
Gayle Sato writes about financial services and personal financial wellness, with a special focus on how digital transformation is changing our relationship with money. As a business and health writer for more than two decades, she has covered the shift from traditional money management to a world of instant, invisible payments and on-the-fly mobile security apps.
Read more from Gayle