What Is Tax Exempt? How Tax Exemption Works

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Tax collection is a necessary part of funding various government programs and services, but sometimes, your money can be tax-exempt. Tax exemptions shouldn’t be seen as a way to avoid taxes, but instead, as a way to encourage certain types of organizations, such as non-profits and charities. However, there can be scenarios in which some of your income or gifts you receive may be tax-exempt, even if you work for a for-profit company.

It’s important to understand the basic rules of tax-exempt status, both because it can reduce how much you owe in taxes, and also so that you are in compliance with IRS rules. And tax exemption doesn’t only exist at the federal level — it also exists at the state and local levels in some cases.

What Does “Tax-exempt” Mean?

Being tax-exempt is to be free from the collection of taxes. However, note that tax-exempt is not all-or-nothing; it can sometimes apply to some, but not all, of the income of a person or organization. Even a single transaction can be partially tax-exempt.

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With tax exemption, there is no need to include the income on your next tax return. Because the money is exempt, you don’t pay tax on the income.

What is the Difference Between Deduction and Exemption?

“Tax-exempt” is different from “tax-deductible.” Tax deductions allow you to reduce the amount you owe in taxes. For instance, contributions to an individual retirement account (IRA) are tax-deductible. Hence, you generally fund these accounts with after-tax income that has already had state & federal taxes withheld, then deduct them on your next return.

Tax deduction and tax exemption, as well as tax credit, result in a reduced tax bill.

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

Types of Tax-exempt Organizations

Certain types of organizations are completely exempt from taxes; these are usually 501(c)(3) nonprofit organizations. According to the IRS, the types of organizations that are tax-exempt are:

You might be wondering if you are required to pay income tax if you work for one of these organizations given that they are tax-exempt. The Social Security Administration says that you may indeed be exempt from federal income taxes if you work for a 501(c)(3).

However, that won’t exempt you from paying Social Security taxes. Even if you work for a nonprofit, you must pay Social Security taxes on any earnings of $108.28 or more.

Good to Know

State and federal withholdings from your paycheck are not tax-exempt. Generally, federal withholdings are more like a tax credit because they are money you’ve already paid to the federal government. Hence, you won’t owe the amount you’ve had withheld come tax time.

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Tax-exempt Benefits and Income

For most individuals, the money you earn from salary or wages is subject to income tax rules. You may be able to deduct a portion, such as with contributions to a retirement account or health savings account. However, the income you receive from your paycheck likely isn’t tax-exempt.

However, there are several examples of money that may be completely exempt from taxes:

If you received any of these, meeting with a tax advisor is always a good idea to be sure you don’t still owe taxes on them. There could be limits or other conditions that affect the exemption. In general, though, you needn’t worry about a hefty tax bill if you receive any of these.

The Bottom Line

Tax exemptions can apply to income or a single transaction, and either one can be only partially tax-exempt. Entire organizations can be exempt from taxes; these are usually 501(c)(3) nonprofits. In addition, tax exemptions can come at the state, local and federal levels.

In other words, tax exemptions are far from all or nothing. They are more like the layers of an onion — or rings of a tree stump, if you prefer. You may have a few layers that are exempt from taxes, while the rest are either tax-deductible, eligible for a tax credit or simply taxed as income.

That’s why it’s a good idea to meet with a tax advisor if you have not done so. They can help you understand the intricacies of the tax code and be sure you are fully compliant. At the same time, they can help you take advantage of any exemptions for which you may be eligible.