Taxes are an unavoidable part of life for most people. You could, however, get out of paying income tax if you’re deemed tax-exempt by the Internal Revenue Service (IRS). But what does tax-exempt mean exactly? In simple terms, if you have tax-exempt status, then you’re not obligated to pay tax on income. It’s a little different from claiming a tax exemption when you file your return. The terms can be confusing so we’ll give a rundown to understand how the IRS defines tax-exempt.
A financial advisor can help you optimize a tax strategy for your financial needs and goals.
What Does Tax Exempt Mean?
Tax-exempt means that income is not subject to taxation. When an individual, business or organization has tax-exempt status, they’re relieved of having to pay tax on some or all of their income. For example, the IRS allows eligible charitable organizations and nonprofits, including religious institutions, to apply for tax-exempt status.
Private foundations and political organizations can also qualify as tax-exempt under Section 501(c)(3) and Section 527 of the Internal Revenue Code, respectively.
Certain types of investments can be tax-exempt. Municipal bonds, which are bonds issued by state and local governments, are typically exempt from federal income tax. Likewise, federal bonds issued by the government are usually tax-exempt at the state and local levels.
Tax-exempt status can be a good thing, as it can translate to tax savings. There are, however, certain requirements that must be met in order to claim that status.
Who Can Be Tax Exempt?
IRS guidelines determine which organizations qualify as tax-exempt under Section 501(c)(3). To be tax-exempt, an organization must:
- Be organized and operated exclusively for exempt purposes, as defined by the Internal Revenue Code.
- Not pay any of its earnings to private shareholders or individuals.
- Not be an action organization that participates in political lobbying, campaigning or legislative activities.
There are additional rules for private foundations. For example, the IRS bars private foundations from engaging in self-dealing. And it requires that income must be distributed for charitable purposes.
Determining whether an individual is tax-exempt works a little differently, as there are different ways it can be interpreted. Specifically, being a tax-exempt individual can mean one of three things:
- You’re exempt from withholding tax through your employer, though you’re still obligated to pay Social Security and Medicare taxes from your earnings.
- You earned or otherwise received income that is not subject to federal income tax.
- You’re exempt from minimum wage and overtime rules, as defined by the Fair Labor Standards Act.
To qualify as exempt from withholding, you generally have to satisfy two conditions. You must have gotten a refund of all your federal income tax withholding for the previous year because your tax liability was $0. And you expect that to repeat for the current tax year.
It’s less common to have income that isn’t taxable, simply because the IRS defines income so broadly. Taxable income includes money you earn from working, running a business or side hustling, for example. But it can also include money that’s unearned, such as dividends or rental income.
You may be tax-exempt if you’re not subject to federal minimum wage and overtime rules. Though, that’s a less common scenario as well.
Is It Good to Be Tax Exempt?
There’s no downside to being tax-exempt since it means that you’re able to avoid paying tax on some or all of your income. For example, if you’re investing in municipal bonds for passive income, you might appreciate not having to pay tax on the interest payments you receive from them.
Generally, anything you can do to reduce your tax liability is a good thing. It means you get to keep more of your money. Paying more in taxes can leave you with less income to fund your goals, whether that be paying down high-interest debt or investing for retirement.
Where you can run into trouble with tax-exempt status is assuming that you’re exempt, when in fact, you’re not. For example, while income from municipal bonds is largely tax-exempt at the federal level, that’s not always the case. Some municipal bonds are taxable, though they may offset that by offering a higher yield than other muni bonds.
Tax Exempt vs. Tax Exemption vs. Exempt Employee
Tax-exempt means income is not subject to taxation. A tax exemption, on the other hand, is a provision in the tax code that allows you to remove certain income from your personal tax equation. Prior to the Passage of the Tax Cuts and Jobs Act in 2017, taxpayers could claim personal and dependent exemptions on their returns, allowing them to reduce the amount of income that was subject to tax.
The federal estate tax exemption allows you to shield part of your estate from taxation, up to certain limits. For 2023, the estate tax exemption limit is $12.92 million for individuals, with the limit doubled for couples. The higher exemption limit was another measure included in the Tax Cuts and Jobs Act and is set to expire at the end of 2025.
An exempt employee is someone who earns a salary that’s above a certain level and works in an administrative, professional, executive, computer or outside sales role. The Department of Labor (DOL) has a duties test that employers can use to determine which employees are exempt.
Non-exempt employees, by comparison, typically earn an hourly wage or salary that’s less than the minimum amount set by the Department of Labor. These employees are entitled to minimum wage and overtime pay benefits as defined by the Fair Labor Standards Act when they work more than 40 hours per week.
The Bottom Line
Taxes can be confusing enough and even more so if you’re unfamiliar with terms like ‘tax exempt’ or ‘tax exemption’. Knowing the difference between them and when each one might apply to you can make filing taxes less stressful. If you’re looking to qualify to be exempt from withholding tax through your employer, you needed to receive a refund of all your federal income tax withholding for the previous year because your tax liability was $0. And you need that to be repeated during the current tax year.
Tax Planning Tips
- Consider talking to your financial advisor about the best ways to minimize taxes through smart investments. SmartAsset’s financial advisor matching tool makes it easy to connect with professional advisors in your local area. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- A tax exemption is not the same thing as a tax credit or a tax deduction. Credits reduce your tax liability on a dollar-for-dollar basis, while deductions reduce your taxable income for the year. Claiming all of the credits and deductions you’re eligible for can be an effective way to shrink your tax bill or potentially increase the size of your refund. An accountant or tax preparer can help you figure out which credits and deductions you might be able to claim if you’re not sure what you qualify for.
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