What Is an Exemption?

An exemption is a deduction allowed by law that reduces the amount of income that is subject to income tax. The Internal Revenue Service (IRS) previously offered two types of exemptions: personal and dependent exemptions. But with the changes brought about by the 2017 Tax Cuts and Jobs Act, the personal exemption is disappearing until 2025. At the same time, the standard amount that can be deducted when filing nearly doubled.

Key Takeaways

  • An exemption is a lawful reduction of the amount of income that would otherwise be taxed for a qualifying reason.
  • Previously, the Internal Revenue Service categorized tax exemptions into two buckets: personal and dependent exemptions.
  • Now, until 2025, personal exemptions have been repealed and replaced by higher standard deductions for both couples and individuals.
  • Certain income, such as income made from municipal bonds or unemployment income, and charitable gifts also count as types of exempted income.
  • The W-4 form allows the taxpayer to claim a withholding allowance, which is an exemption that reduces how much income tax an employer deducts from the employee's paycheck.

How an Exemption Works

The personal exemption was repealed with the 2017 reforms but was essentially replaced with higher standard deductions for both couples and individuals. This change was among many in the Tax Cuts and Jobs Act. When filing taxes, exemptions can work in your favor based on your personal financial situation, especially when itemizing.

Personal Exemptions

Personal exemptions were allowed by the IRS through the 2017 filing year, with individual tax filers able to claim $4,050 for each taxpayer, spouse, and dependent child. Previously, for example, a taxpayer who had three allowable exemptions could have deducted $12,150 from their total taxable income. However, if that person earned over a certain threshold, the amount of the exemption would have been phased out and eventually eliminated.

Tax filers were only able to claim a personal exemption if that person was not claimed as a dependent on someone else's income tax return. This rule intentionally set exemptions apart from deductions.

For example, take a college student with a job whose parents claimed him or her as a dependent on their income tax return. Because someone else claimed the student as a dependent, the student could not claim the personal exemption but could still claim the standard deduction.

In most cases, tax filers could also claim a personal deduction for a spouse, as long as the spouse was not claimed as a dependent on another person's tax return.

Dependent Exemptions

In many cases, dependents most commonly include the minor children of the taxpayer. However, taxpayers may claim exemptions for other dependents as well. The IRS has a litmus test for determining who is considered a dependent, but in most cases, it is defined as a relative of the taxpayer (parent, child, brother, sister, aunt, or uncle) who is dependent on the taxpayer for support.

The so-called child tax credit doubled to $2,000 per child under the new law, from $1,000 per dependent previously.

For the 2021 tax year, the Child Tax Credit has been raised to $3,000 for children ages six through 17 and $3,600 for children under six. This change is part of the American Relief Act. The credit will be paid monthly, not at tax time, and is a full refund, not partial depending on income. The credit is phased out for singles with incomes above $75,000 and couples with incomes above $150,000.

Exemption From Withholding

Employers withhold income tax from their employees and remit it to the IRS. However, a person who has no tax liability can request an exemption from withholding. This simply means that the employer will withhold Medicare and Social Security contributions from the person's paycheck, but will not withhold income tax.

Examples of an Exemption

The W-4 form allows the taxpayer to claim a withholding allowance, which is an exemption that reduces how much income tax an employer deducts from the employee's paycheck. Every time an individual starts a new job, they are required to fill out the W-4, which helps the employer estimate how much money to remit to tax authorities. Exemptions, in addition to the personal and dependent exemptions mentioned above, can come in many forms.

Income Exemptions

Certain kinds of exempt income from municipal bond income, unemployment income, gifts under $15,00, and any distributions from health savings accounts (HSA) used for qualified medical expenses will be not taxed.

Charitable Giving Exemptions

Cash donations made to any qualifying charities or other tax-exempt organizations also qualify as a deduction on your overall taxes. Organizations can include churches, community foundations, fraternal society, civil defense organizations, or other qualified organizations.

For taxpayers with an adjusted gross income of less than $150,000 in 2020, the American Rescue Plan allows tax exemptions for up to $10,200 in unemployment benefits paid in 2020.

Exemption FAQs

What Is the Meaning of Exempted?

According to the Oxford Dictionary, "exempted" means that something is free from an obligation or liability imposed on others.

What Exemptions Can I Claim?

Exemptions fall into two categories: personal and dependent exemptions.

What Does Exemptions Mean on Unemployment?

For taxpayers with an adjusted gross income of less than $150,000 in 2020, the American Rescue Plan allows tax exemptions for up to $10,200 in unemployment benefits paid in 2020.

What Is an Exemption When Filing Taxes?

Exemptions include certain line items, dependents, or personal situations that are excluded from an individual or household's total taxable income.

How Many Federal Exemptions Should I Claim?

Typically speaking, individuals can claim one personal tax exemption for themselves, and one for a married spouse. Each dependent in your family, whether a child or someone under your care, counts as an additional tax exemption. However, it's recommended you use the IRS' Tax Withholding Calculator to get a better idea of your tax situation.

The Bottom Line

Exemptions are essential to understand and claim on your federal tax returns, by knowing how you can reduce your total taxable income and keep as much of your hard-earned money as possible. While exemptions used to make a bigger difference in calculating your annual taxes prior to the 2017 Tax Cuts and Jobs Act, before the standard deduction was increased, they still can drastically change your tax situation.