Tax exemptions let individuals and organizations avoid paying taxes on some or all of their income. Exemptions were once available to almost all tax filers in the form of personal exemptions. However, in 2017 the personal tax exemption was eliminated as part of the Trump tax plan. Still, exemptions are still important tax-saving tools. Here’s what you need to know about tax exemptions and how they differ from tax deductions and tax credits. For proper tax planning, consider working with a financial advisor.
What Is a Tax Exemption?
A tax exemption is a legal means of reducing taxable income. There are two types of federal tax exemptions, personal and dependent. With the passage of the 2017 Tax Cuts and Jobs Act, the federal government did away with personal tax exemption, beginning with the 2018 tax year and until the 2025 tax year. However, you may still need to use the personal tax exemption if you are filing an amended 2017 return.
Dependent exemptions, which remain, are based on the individuals in your household. Depending on your situation, you may be able to take exemptions for children, spouses and adults with particular needs. The IRS would consider those individuals tax-exempt up to a certain amount of money, again reducing your taxable income.
AMT Tax Exemption
One exemption that remains after reform is the alternative minimum tax (AMT) exemption. The AMT is a separate way of figuring taxes that are designed to keep high earners from paying no income taxes. High-income filers have to calculate their taxes using the AMT approach as well as the regular approach and then pay whichever amount is higher.
The AMT exemption exists because, with the passage of time and inflation, some lower-income taxpayers have become subject to the AMT. Since this isn’t the intention of the tax, lower-income taxpayers get to exempt some income from AMT calculations. The amount of this exemption also changes from year to year. For individual filers, the AMT exemption is $72,900 for 2020. Married couples filing jointly in 2020 can exempt $113,400 of income from the AMT calculations.
Exemptions vs. Deductions
Tax exemptions resemble tax deductions as both of them let taxpayers reduce the amount of taxes they owe by reducing the amount of income subject to taxes. The difference is that deductions, with the exception of the standard deduction, are based on the number of eligible expenses a filer can claim. The size of the mortgage interest deduction, for example, depends on how much the taxpayer paid in mortgage interest during the tax year. Generally speaking, paying $10,000 in mortgage interest means a $10,000 reduction in taxable income.
Some people and businesses can reduce the amount of income tax they owe to zero. This can happen if their deductible expenses equal or exceed the income they earned. They also can carry forward losses from prior years and apply them to shelter income earned in the current tax year. In some cases, taxpayers can even get refunds on previously paid taxes by applying losses that occurred in later years.
The standard deduction, which was doubled in the 2017 Tax Cuts and Jobs Act to compensate people for losing the personal exemption, operates similarly to the personal tax exemption. It also changes year to year and is set for 2020 at $24,800 for married couples filing jointly and $12,400 for single filers. The standard deduction is available to all filers, much like the personal exemption used to be. However, taxpayers can’t claim multiple standard deductions as a taxpayer with, for instance, a large family of dependent children could do.
If you don’t want to take the standard deduction, you can itemize your deductions instead. Itemizing involves listing individual expenses that you want to write off on your return. Itemizing your deductions generally makes the most sense if the value of all your deductible expenses (like charitable donations, unreimbursed business expenses, job hunting expenses, etc.) exceeds the standard deduction.
The dollar value of an exemption or a deduction, like the standard deduction, varies depending on the taxpayer’s tax rate. To a taxpayer paying taxes at a rate of 10%, the lowest bracket, the $12,400 single-filer standard deduction will reduce the tax bill by $1,240. To a taxpayer in the top bracket, 37%, the savings would be $4,588.
Exemptions vs. Credits
Tax credits differ from both exemptions and deductions. Rather than reducing the amount of income that gets taxed, tax credits directly cut the amount of the tax itself.
A $1,000 tax credit means paying $1,000 less, that is, for a taxpayer in any tax bracket. A $1,000 deduction or exemption for a filer in the 15% bracket, on the other hand, saves just $150. So tax credits are significantly more valuable.
Tax-Exempt Organizations
Tax law exempts nonprofit organizations from paying income taxes. Charitable nonprofits that aim to benefit the public welfare get a pass on all income taxes. For-profit entities such as business corporations can reduce their tax bills by claiming deductions, exemptions and credits.
Charitable organizations, known as 501(c)3 organizations after the tax code section that describes them, don’t pay any income taxes regardless of expenses.
The Bottom Line
Tax exemptions, like tax deductions and tax credits, let individuals pay less in taxes. Exemptions aren’t as important for most taxpayers since the 2017 tax reform eliminated the personal tax deduction and increased the standard deduction. Tax credits, which can save more because they directly reduce the tax bill, are still widely used. The IRS provides a list of all tax credits and deductions for individuals and businesses. If you’re using tax preparation software, that software will walk you through potential exemptions, deductions and credits to make sure you’re claiming everything you can.
Tips on Tax Planning
- Any time you are preparing a tax return and want to make the best use of exemptions, deductions or credits, an experienced financial advisor can provide valuable assistance. Finding a financial advisor doesn’t have to be hard. SmartAsset’s matching tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- In addition to income taxes, state tax exemptions exist. For instance, charitable nonprofits are generally exempt from paying local property taxes. Using a free income tax calculator is a good way to check that your own tax calculations are accurate.
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