What Is a Tax Exemption and How Does It Work?

woman explaining to a couple how tax exemption works

What do tax exemptions mean for you? Put simply, they can mean a larger tax refund, which leaves more money in your pocket. Your tax liability, including tax exemptions, can either save or cost you when you file your taxes this season. In the past few years, tax exemption laws have changed significantly, so take some time to update your knowledge of how to find and use every tax exemption possible.

What Does It Mean to Be Tax Exempt?

Tax exemptions are income, transactions or organizations that are entirely excluded from taxation. Tax exemptions differ based on various qualifications and according to federal and state law.

The IRS exempts institutions such as certain charitable organizations, or portions of an individual's income, from taxation. State laws may expand on federal tax exemptions or institute their own, sometimes for surprising reasons. For instance, Florida's "greenbelt law" provides exemptions for landowners with a few cows on their property.

When you qualify for a tax exemption, for whatever reason, your taxable income is effectively reduced based on the amount of the exemption and the current coinciding income tax.

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Tax Exemptions, Tax Deductions and Tax Credits

Tax exemptions, tax deductions and tax credits all have the potential to save you money. Understanding the differences is the key to making the most out of any tax breaks available.

  • Tax exemptions refer to income that isn't taxable in the first place. For example, payments you received for a work injury are exempt, so you don't have to claim that cash as taxable income.
  • Tax deductions, on the other hand, are ways to exclude some of your income (or, reduce your gross income) based on qualifying expenses you've incurred. Common tax deductions include student loan interest or charitable donations. Other qualifying deductions can be surprising: For example, Hawaii provides tax deductions for expenses incurred caring for an "exceptional tree" on your property.
  • Tax credits offer dollar-for-dollar reductions for your tax bill, and they directly lower your tax liability. For example, buying an electric car can potentially earn you a tax credit of up to $7,500.

Who Qualifies for a Tax Exemption?

If you qualify for a tax exemption, that income does not need to be claimed on your taxes. But how do you know if you qualify?

In 2017, changes in federal tax law went into effect with the Tax Cuts and Jobs Act. The law overhauled some tax applications, like doubling estate tax exemptions, which is useful if you're looking into certain trust options while estate planning.

Previously, you could get a tax break using personal exemptions and claiming dependents, but these are no longer available. At that time, taxpayers could claim a personal exemption of up to $4,050, along with claiming their spouse and any dependents. When the new law was implemented in 2018, those dependency exemptions, along with the standard deduction, transitioned into the present-day child tax credit. In 2021, the child tax credit was up to $3,600 for each qualifying dependent.

That said, there are other possible tax exemptions, which include:

  • Child-based income: Child support, foster care or employer-assisted adoption may be tax exempt.
  • Your home: Owning a home can provide certain tax exemptions depending on the situation, such as from government disaster relief and the profits from selling your home.
  • Investments: Interest earned on municipal bonds or withdrawals from your Roth IRA may qualify as tax exempt.
  • Inheritances, gifts and accelerated death benefits: These may be tax exempt depending on your state and other factors.
  • Energy-saving home renovations: Modifying your home to be more energy efficient can earn you subsidies which count as tax-exempt income.
  • Academic scholarships: Scholarships may also be excluded from your taxable income, as long as the award is used to pay for school-related expenses such as tuition, books and other supplies.

To learn whether you qualify for certain tax exemptions, consider consulting a tax preparer or financial advisor. Filing your taxes with a professional can help ensure you don't miss out on any relevant tax exemptions, among other potential tax breaks.

Even without going straight to a professional, you have options to get the best out of your tax season. Check to see if you qualify for free tax preparation and filing. You can also peruse various tax-prep software to secure a pleasant-as-possible end to your tax year.

The Bottom Line

Whether you're hoping to protect your assets or you're in a financial pinch this tax season and don't want to pay more than you owe, tax exemptions could be significant when it comes to calculating how much you owe.

Make sure to use every applicable exemption this season, and plan out your year with the next tax season in mind. When you're tuned in to the tax exemptions, tax deductions and tax credits available, you can feel more assured that you're not overpaying come tax time.