What Does It Mean to Be Tax-Exempt?

Tax-exempt means not being required to pay taxes on certain types of income. Individuals can qualify for tax-exemptions. Entire organizations can be completely tax-exempt.

Tax-exempt does not mean you don’t have to report the income on your tax return. However, it will not be added to your taxable income on your return.

Types of Tax-Exempt Entities

Tax-exempt entities are organizations that don’t have to pay income tax on any income. These organizations don’t report a profit. Instead they use funds for organizational purposes. 

Non-Profit Organizations

Non-profit organizations are charities and other organizations that receive income in the form of donations. These donations could be cash or other assets. The donations are then given to those in need, or are used for other charitable purposes. 

Non-profit organizations don’t have excess contributions. All funds are used to pay for organization expenses, and used for the purposes of the organization. For example; Goodwill stores receive donated goods, re-sell these goods and use the funds to help with job training and placement.

This means income in a non-profit is tax-exempt when being used for the purposes of the organization in compliance with IRS regulations.

Government Entities

Government agencies are typically funded by taxes, but can also earn money in other ways. The funds received in these organizations are tax-exempt.

Whether it’s the police force, public schools or another government organization, there are no taxes levied on the income collected for use in government agencies.

Religious Groups

Religious groups and churches are typically tax-exempt organizations. Most are required to file as a 501(c)(3) to receive tax-exempt status.

The donations collected by religious organizations are used for the mission and operation of the organization itself. Income from donations is considered tax-exempt, and these organizations do not need to pay income tax.

Do Employees of Tax-Exempt Organizations Pay Taxes?

You will still have to pay income tax if you are an employee at a tax-exempt organization. Your employer is generally required by law to withhold federal income tax from employees’ wages.

Even if you work for a nonprofit, you must pay Social Security taxes on any earnings above $108.28.

If your employer doesn’t participate in Social Security, the employer won’t withhold FICA tax from your pay and won’t pay its share on your behalf, so you’ll have to pay both your share and the employer’s at tax time.

Tax-Exempt Investments

There are several ways to earn tax-exempt income through investing. There are also different investments and accounts that allow you to avoid paying income taxes. 

• Municipal bonds pay interest that is exempt from federal taxes — and may also be exempt from state and local taxes as well.
• Roth IRAs allow your contributions to grow tax free. Once you’re retired, your withdrawals are also tax free.

Tax-Exempt Income

Certain types of income may be exempt from income taxes. 

• Gifts and estates. If you give a gift (money or otherwise), there is an exemption of up to $18,000 per year, per individual ($19,000 in 2025). You can also give more than that, as there’s a lifetime gift tax exemption of $13.61 million, per individual ($13.99 million in 2025).
• Scholarships. However, it is only tax-exempt if used for the intended purposes spelled out by the scholarship itself. 
• Disability benefits. You will need to report the disability income on your tax return, but won’t have to pay taxes on it.

Here are a few other examples of tax-exempt income:

• Workers’ compensation
• Supplemental Security Income
• Child support
• Welfare payments

Tax-Exempt vs. Tax-Deferred

Tax-exempt and tax-deferred are similar things — but they are not the same.

Tax-Deferred

Tax-deferred income is not taxed in the year you earn it — but rather deferred until later. For example; If you contribute to a traditional IRA, you can defer income taxes until you start withdrawing from the account in retirement.

Tax Exemptions

Tax exemptions, on the other hand, don’t reduce the amount of tax you owe — the money is untaxed, so it doesn’t affect your tax situation. The income is never taxed, so you won’t have to account for it later.

These differences seem minor but can have a big real-world impact. You can realistically have thousands of dollars that are deductible but not entirely exempt from taxes.

IRS Rules That Can Revoke Your Tax-Exempt Status

Tax-exempt status isn’t permanent; it comes with strict rules. The IRS can revoke an organization’s exemption if it fails to operate within legal and regulatory guidelines.

Common reasons for losing tax-exempt status include:

• Engaging in political or lobbying activities beyond what’s allowed under IRS rules, especially for 501(c)(3) charities.
• Using funds for illegal or non-charitable purposes, including personal benefit or private interests.
• Failure to file required annual returns, like Form 990, for three consecutive years.
• Lack of transparency, including not making governing documents or filings available to the public when required.

Losing tax-exempt status means the organization becomes subject to federal income tax and may face penalties or reputational damage. To avoid issues, it’s critical to maintain compliance, keep thorough records, and stay up to date on IRS requirements.

The Bottom Line

Tax-exempt income means you never have to pay taxes on it. You can have tax-exempt income as an individual, or entire organizations can operate as a tax-exempt entity.

Understanding how tax-exemption works can help you make tax-smart decisions and ultimately save money on your income taxes. But not everyone can qualify for tax-exempt income, and organizations that want tax-exempt status must follow a strict set of rules to qualify.