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This article was fact-checked by our editors and Rachel Weatherly, tax product specialist with Credit Karma Tax®. It has been updated for the 2020 tax year.
Tax breaks like tax exemptions can reduce your taxable income, but not all breaks are available to all taxpayers.
Even so, it’s important to understand how a tax break like an exemption works, how they can affect your tax bill, and other ways you may be able to reduce how much you owe each year. It can also help you understand which tax-exempt organizations can qualify you for a charitable contribution deduction if you donate to them.
Here are some things to know about tax exemptions and how they work.
- What do tax exemptions mean?
- Why is it important to understand how tax exemptions work?
- How could this affect my taxes?
- Things to know about other ways to reduce your tax bill
A tax exemption is a type of tax break that reduces your taxable income or zeroes it out entirely. In this way, an exemption is similar to a tax deduction, which helps reduce your taxable income when you file your federal tax return.
The difference is you have to meet certain requirements to qualify for a tax deduction that will reduce the amount of your income subject to tax. With an exemption, the income isn’t subject to tax in the first place.
In contrast, a tax credit directly reduces your tax liability after your taxable income has been calculated, so it functions differently than an exemption.What's the difference between tax deductions and tax credits?
Types of tax breaks
There are different types of tax breaks for both individuals and organizations. But the big exemption for individuals, the personal exemption, was suspended until 2026 under the Tax Cuts and Jobs Act of 2017. The personal and dependent exemptions allowed you to exempt a set dollar amount from your taxable income for you, your spouse (if married filing jointly), and each of your dependents.
Another type of “exemption” you may be familiar with is the withholding exemption. Individual taxpayers can claim an exemption from tax withholding on their paychecks if they had no income tax liability in the previous tax year and expect the same in the current tax year. That’s not really a tax break, though — if you make more money than you expect, you could still end up owing at tax time.
Finally, certain types of nontaxable income are exempted from being included in taxable income, including …
- Alimony (depending on factors like when you divorced)
- Child support
- Eligible workers’ compensation
- Eligible municipal bond interest (federal income taxes only)
- Treasury bill interest (state and local income taxes only)
To exclude a certain type of income, you typically have to meet certain conditions, so make sure you double check the income qualifies before excluding it from your taxable income.
Organizations that qualify for tax-exempt status (which is different from a tax exemption) include those that provide services to the public, such as charitable organizations, churches and religious organizations, social clubs, fraternal societies, veterans organizations and more. Qualified organizations may be exempt from state sales, property and income tax, as well as federal income tax.
How much can I deduct for charitable contributions?
In most cases when you donate cash, the amount you can deduct for charitable contributions to qualified charities is a percentage of your adjusted gross income. For 2020, that amount is 60% of your AGI.
If you’ve received a type of income that’s exempt from federal or state income tax (or both), it’s important to know it so that you don’t overpay. The same goes if you didn’t have any income tax liability at all last year — if you can avoid having taxes withheld from your paycheck, you can have more money in your pocket and working for you throughout the year.
While tax-exempt status for organizations may not be as important to individual taxpayers, it may be a good idea to check for it if you’re planning to donate to one. If you donate money to an organization that doesn’t qualify for tax-exempt status, it means they don’t meet the requirements set by the IRS and your contributions may not be tax-deductible.
Qualifying for a tax break can reduce your taxable income or potentially exempt you from tax withholding from your regular paycheck.
The suspension of the personal exemption may also affect your taxes. In 2017, you could typically deduct $4,050 for each exemption you were eligible to take. Depending on how big your family is, the loss of personal exemptions could potentially increase your taxable income.
Unfortunately, though, it’s not easy to determine the direct impact of the suspension, because Congress also substantially increased the standard deduction amount for all filing statuses and doubled the child tax credit, which could potentially offset some or all of the loss from personal exemptions.
While personal exemptions are no more, and not everyone qualifies for other tax exemptions, there are other ways you may be able to reduce your tax bill. Here are some examples, but make sure to do your research first because there are typically eligibility requirements.
- Itemizing your deductions if they exceed the standard deduction.
- Contributing to a tax-advantaged retirement account, such as a 401(k) or traditional IRA.
- Contributing to a health savings account or flexible spending account.
- If you’re a business owner, keeping track of your business expenses.
- Making energy-efficient improvements to your home.
- Preparing and filing your taxes for free with an online service, like Credit Karma Tax®, which can suggest deductions and credits you may qualify for based on information you provide.
If you’ve been wondering, “What do tax exemptions mean?” you should now have a better idea of what they do and how they might affect you. While the most common exemption for individual taxpayers is not currently available, there are still other tax breaks you may be able to take advantage of.
You may be able to reduce your tax obligation by researching tax deductions or tax credits that you may qualify for.
Rachel Weatherly is a tax product specialist with Credit Karma Tax®. She studied accounting and finance at Western Carolina University and has also worked as a tax analyst. You can find her on LinkedIn.