What Does It Mean to Be Tax Exempt? - NerdWallet (2024)

Being tax-exempt or having a tax exemption seems like a way to lower your tax bill, but it can get you in trouble if you don't understand the difference between tax exemptions, exempt workers and tax-exempt status. Here’s how those terms tend to appear in the wild and how you can make them work for you.

What does tax-exempt mean?

Being tax-exempt means that some or all of a person's or business's income is free from federal, state or local tax. Tax-exempt organizations are typically charities or religious organizations recognized by the IRS. They’re exempt from federal taxation (that is, they have tax-exempt status), and donations to them are typically tax-deductible.

What qualifies you to be a tax-exempt individual?

For individuals, this term often has three meanings.

1. Are you exempt from withholding tax?

You may be able to elect to have federal income tax withheld from your paychecks by changing your W-4 at work. Social Security and Medicare taxes will still come out of your check, though.

Typically, you can be exempt from withholding tax only if two things are true:

2. Did you receive income that isn't taxable?

This is rare, because the Internal Revenue Code defines taxable income as gross income minus deductions. And gross income, federal law says, “means all income from whatever source derived.”

That’s a lot of territory, covering earned income such as wages and unearned income from investments and other sources. However, there are some types of income that typically aren't subject to tax.

3. Are you exempt from minimum wage and overtime rules?

The Fair Labor Standards Act requires that most workers get paid at least minimum wage and overtime. However, some people in executive, administrative, professional and outside sales jobs are exempt from those rules.

The Labor Department uses a few tests to determine whether an employee is exempt from the minimum wage and overtime rules, which generally have to do with pay and job duties. You can visit the department's website for more information.

What is a tax exemption?

A tax exemption is the right to exclude certain income or activities from taxation. Up until 2018, taxpayers were able to exclude up to $4,050 for each eligible individual off their income by claiming personal exemptions. Personal exemptions no longer exist.

The difference between tax exemptions, tax deductions and tax credits

Tax exemptions aren’t the same as tax deductions or tax credits.