Posted by James Financial Services Inc

What Is An Exemption?

What Is An Exemption?

An exemption is a legally permitted deduction that reduces the amount of income subject to income tax. The IRS previously offered two exemptions: personal exemptions and employee exemptions. But with the changes made by the TCJA, 2017 (Tax Cuts and Jobs Act), the personal exemption will stop existing by 2025. At the same time, the standard deductible amount when filing your return has almost doubled.


Summary 

  • An exemption is a statutory reduction in the amount of income that would otherwise be taxed for a qualified reason.

  • Certain income, such as municipal bond income or unemployment income, and charitable donations are also considered exempt types of income.

  • Until 2025, personal exemptions have been canceled and replaced with higher standard deductions for couples and individuals.

  • Previously, the IRS classified tax exemptions into two categories: personal exemptions and employee exemptions.

  • The W-4 form enables the taxpayer to claim a withholding tax, which is an exemption that reduces the amount of income tax that an employer deducts from the employee's wages.


How an exemption works

The personal exemption was abolished with the 2017 reforms but essentially replaced by higher standard deductions for couples and individuals. This change was one of many changes that came with the Tax Cuts and Jobs Act. When you file your tax return, the exemptions may work to your advantage depending on your financial situation, especially when you are itemizing.


Personal exemptions

The IRS allowed personal exemptions until the 2017 tax year, and individual taxpayers could claim $4,050 for each taxpayer, dependent child, and spouse. Previously, for example, a taxpayer with three permitted exemptions could have deducted $12,150 from their total taxable income. However, if that person earned above a certain threshold, the exemption amount would have been phased out and eventually eliminated.

Taxpayers can only claim a personal exemption if that person is not listed as a dependent on someone else's tax return. This rule intentionally separates exemptions from deductions.

For example, consider a student with a job whose parents claimed him as a dependent on their tax return. Because the student has been claimed as a dependent by someone else, the student cannot claim the personal exemption but can claim the standard deduction.

In most cases, taxpayers can also claim a personal deduction for a spouse, provided the spouse has not been declared dependent on someone else's tax return.


Exemptions for dependents

In many cases, dependents generally include the taxpayer's minor children. However, taxpayers can also claim exemptions for other dependents. The IRS has a litmus test to determine who is considered a dependent. Still, in most cases, it is defined as a relative of the taxpayer (father, son, brother, sister, aunt, or uncle) who depends on the taxpayer for support.

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

For fiscal 2021, the child tax credit increased to $3,000 for children aged 6 to 17 and $3,600 for children under 6. The credit will be refunded monthly, not at the time of your tax return, and is a full, partial, and income-based repayment. The credit will be phased out for singles with incomes over $75,000 and couples with incomes over $150,000.


Exemption from withholding

Employers withhold income tax from employees and send it to the IRS. But, a person who has no tax liability can apply for exemption from withholding tax. It just means that the employer will withhold social security contributions and health insurance from the person's wages but will not withhold income tax.


Examples of exemptions

The W-4 form enables the taxpayer to claim withholding tax, which is an exemption that reduces the amount of income tax that an employer deducts from the employee's wages. Whenever a person starts a new job, they have to complete Form W-4, which helps the employer calculate the amount to send to the tax authorities. The exemptions, in addition to the personal and salary exemptions mentioned above, can take various forms.


Income exemptions: Certain types of income exempt from municipal bond income, unemployment income, donations under $1500, and distributions from health savings accounts (HSAs) used for qualifying medical expenses will not be taxed.


Exemptions from charitable donations: Cash donations made to qualified charities or other tax-exempt organizations may also be deducted from their general taxes. Organizations may include churches, community foundations, fraternal societies, advocacy organizations, civil or other qualified organizations.

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


Bottom Line

Exemptions are essential for understanding and claiming your federal tax returns, knowing how you can reduce your taxable income, and keep as much of your hard-earned income as possible. Although the exemptions made a bigger difference in calculating annual taxes before the Tax Cuts and Jobs Act (TCJA), they can still drastically change your tax situation before the standard deduction was increased.


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