What Are Tax Exemptions? Here's What You Need to Know
If you’re anything like us, the phrase “tax exemptions” probably elicits a unique mix of reactions — yawns, anxiety, and maybe a hint of curiosity (after all, being “exempt” from taxes sounds like it could be a good thing — right?).
Your accountant friends would likely strongly disagree, but from where we stand, we’re not sure whether we’d rather nod off or run off as soon as the word “taxes” is introduced into otherwise polite conversation. The tedium! The terror! It’s all just too much.
Luckily for you, we’re here to take some of the total drudgery out of taxes and finance for you with simple, straightforward guides to these often intensely banal subjects, beginning with tax exemptions.
What Are Tax Exemptions?
A tax exemption is — you guessed it — a type of monetary exemption that either reduces or eliminates the amount you owe to the federal government. It can take many forms; charitable organizations, for example, are exempt from paying property and income tax, and many veterans are exempt from paying property tax. Churches and other religious institutions also qualify as tax-exempt organizations, too.
For the majority of us, though, there are two main types of exemptions: personal exemptions and dependent exemptions. The latter of these is claimed by parents or legal guardians who are able to lower the taxes taken out of their Adjust Gross Income (AGI) simply by filing their children as dependents.
How Do You Claim Tax Exemptions?
Claiming tax exemptions is typically done on your W-4, a form you must file with any employer as a new employee. On a W-4, exemptions are called “allowances,” and based on the number you claim, your employer withholds a certain amount of your wages from each paycheck to allocate to taxes. The more allowances you claim, the less federal income tax will be withheld from your wages — meaning, the more money you get to keep in your take-home pay.
However, before automatically assuming that more take-home pay is always better, don’t forget that this doesn’t change the fact you’ll still owe the IRS taxes at the end of the year, and that the amount of taxes your employer withholds is credited toward that sum. So, if you claim too many allowances and don’t have enough federal income tax withholding (or FITW), you’ll wind up owing the feds come year’s end. If you have a surplus of FITW, though, you’ll be due a refund. The challenge you, dear taxpayer, are faced with is figuring out the proper amount of allowances so that you strike a balance between income accessible throughout the year and what you’ll (ideally!) be refunded post-April 15th. Note that you also don’t have to claim the full number of allowances you qualify for if you don’t want to.
Can You Mark That You're Totally Exempt?
Some people sure can! But to have tax-exempt status (from paying income tax, specifically), you have to meet multi-layered, specific criteria based on things like age, income, and ability. For example, if you're single, under the age of 65 and your yearly income is less than $12,000, or you're married and under 65 years old with an income of less than $24,000, you're exempt from paying taxes.
Some other examples of people who qualify as exempt:
- Full-time students under the age of 24
- Those aged 19 or younger
- Anyone who is a disabled veteran (war veterans also qualify for a special tax credit specific to which war they fought in)
- Those who are legally blind
If you do, in fact, qualify as exempt, you can report that on your W-4 form by leaving box 5 black and writing “EXEMPT” in box 7. This will prevent any withholdings from your paycheck. But be sure to do your research and 100% verify that you truly are exempt before marking this, as the penalty for making yourself exempt when you aren’t can be pretty steep.
Remember that even if a person has a tax-exempt status, that only pertains to income taxes. They’re almost certainly still paying another form of tax, like sales tax, property tax, Social Security and Medicare taxes, or user taxes on items like gasoline, tobacco, and alcohol.
What Are Tax Exemptions for Medical Expenses?
"If you itemize your deductions for a taxable year on Form 1040, Schedule A.pdf, Itemized Deductions, you may be able to deduct expenses you paid that year for medical and dental care for yourself, your spouse, and your dependents," according to the IRS. "You may deduct only the amount of your total medical expenses that exceed 7.5 percent of your adjusted gross income. You figure the amount you're allowed to deduct on Form 1040, Schedule A."
You can deduct any expense paid for preventing, diagnosing, and/or treating a physical or mental illness on your tax return, as well as any expenses you encountered modifying a part of the body for health purposes. Meaning the nasal surgery you underwent to fix your deviated septum counts; the surgery undergone for cosmetic purposes only doesn’t. What’s more, you can even get a tax credit for the travel expenses you accumulated getting to the location of whatever medical care you received. The cost of prescription drugs, insulin, and health insurance premiums can be deducted, too.
Relevant side note: AGI in the U.S. is a person’s total gross income minus deductions. So, taxable income is adjusted gross income minus whatever allowances/exemptions/itemized deductions you’ve claimed.
What Are Tax Exemptions for Education Expenses?
Some education-based taxable exemptions that are attainable include:
- A college/higher education tuition exemption valued at a maximum of $4,000 deduction (however, this deduction drops to $2,000 and then disappears entirely as your income level rises).
- The American Opportunity Credit, OR the Lifetime Learning credit, which can alternately be used to provide at least a small deduction. You can claim 20 percent of the first $10,000 you paid toward tuition and fees in 2018, for a maximum of $2,000.
- Education Savings Accounts (or ESAs) also allow a maximum of $2,000/year to be allocated by parents on behalf of each dependent under age 18 to build up an education savings. Though these savings aren’t tax deductible, they can eventually be withdrawn tax-free — so long as they are, indeed, used to pay for college costs for either that dependent or another member in the family. ESAs are not permissible for some in higher income brackets.
- Interest accumulated on students loans can be tax-deductible, too! Deduct up to $2,500 from your taxable income if you paid interest on your student loans.
What Other Exemptions Exist?
Here are some other tax deductions and credits you can claim on your taxes. And you can read more about them on the IRS page here.
American Opportunity
This lets you claim all of the first $2,000 you spent on tuition, books, equipment and school fees — but not living expenses or transportation — plus 25% of the next $2,000, for a total of $2,500.
Adoption
For the 2018 tax year, the adoption credit covers up to $13,840 in adoption costs per child.
Charitable Donations
If you itemize, you may be able to subtract the value of your charitable gifts from your taxable income.
State and Local Taxes
You may deduct up to $10,000 (or $5,000 if you're married and filing separately) for a combination of property taxes and either state and local income taxes or sales taxes.
Mortgage Interest
The mortgage interest tax deduction cuts the federal income tax that qualifying homeowners pay by reducing their taxable income by the amount of the interest they pay on their mortgages.
Home Office
If you use part of your home for business-related activity, the IRS will let you write it off as associated rent, utilities, real estate taxes, repairs, maintenance and other related expenses.
401(k) Contributions
The contribution limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan is increased from $18,500 in 2018 to $19,000 in 2019. And the limit on annual contributions to an IRA, which last increased in 2013, is increased from $5,500 to $6,000, according to the IRS. The additional catch-up contribution limit for individuals aged 50 and over is not subject to an annual cost-of-living adjustment, so it remains $1,000.
Residential Energy
This credit can get you up to 30 percent of the installation cost of solar energy systems back. This includes solar water heaters and solar panels, for examples.
What Do Dependent Exemptions Entail?
Generally, you can claim 20 to 35 percent of up to $3,000 of day care and similar costs for a child under 13, an incapacitated spouse or parent, or another dependent, as well as up to $6,000 of expenses for two or more dependents.
Dependents don’t necessarily mean biological children only, but extend to other relatives as well. The IRS gives out a test to measure for dependency, and based on that test’s results, the following people could also be claimed as a dependent by you if they meet all five criteria:
- The person is either a relative or a full-time member of your household.
- The person is a citizen or resident of the U.S. or a resident of Canada or Mexico.
- The person did not file a joint income tax return with anyone else.
- You provided over half of the person’s support.
- The person in question has less than $4,050 of gross income.
Additionally, beyond meeting the above criteria, the person’s relationship to you has to fall within one of the following categories: grandchildren; stepchildren; siblings, including half or step-siblings; parents; grandparents or other direct ancestors; stepparents; aunts; uncles; nieces; nephews; parents-in-law; children-in-law; or brothers or sisters-in law.
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