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Something that is tax exempt isn’t subject to taxation. For individual taxpayers, certain items of income are called exemptions. For entities that serve either the public or their specific members, all income is exempt, and the entities are defined as “tax exempt organizations.”
In 1789, Benjamin Franklin wrote, “Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.”
It stands to reason, then, that understanding tax obligations and knowing how to file a tax return is a fundamental component of financial literacy. Tax exemptions are a significant part of determining how much money a taxpayer owes the government for the tax year.
Local, state, and federal governments can make income, property, and specific transactions, in whole or in part, tax exempt.
Income Tax Exemptions for Individuals
There are three common components that help individual taxpayers reduce their tax bill. Taxpayers can claim deductions to calculate a lower adjusted gross income. They can apply credits to eliminate taxes due on a dollar-for-dollar basis. And tax exemptions can reduce the amount of income subject to tax.
The best-known tax exemption available to individual taxpayers is the personal exemption. The personal exemption reduces one’s income by $4,050 and can be applied to the filer, his or her spouse and any dependents they claim on their return.
So, for example, a family of four (mom, dad, and two kids) could claim a personal exemption of $16,200. Unfortunately, the Tax Cuts and Jobs Act of 2017 put a moratorium on the personal exemption through the year 2025. Until then, this same family will be entitled to a higher standard deduction and increased child tax credit.
Examples of other exemptions include interest on municipal bonds, life insurance proceeds, disability insurance payments, and income from a Roth IRA. For married taxpayers who have lived in a primary residence for at least two of the past five years, up to $500,000 in capital gains can be exempt from tax when they sell their house.
But exemptions are not limited to income tax.
Other Exemptions Not Related to Personal Income Tax
Exemptions also apply to gift and estate taxes. Up to $15,000 a year are exempt from gift taxes. Married couples can each give away up to $11,580,000 over the course of their lifetimes exempt from such taxes. This lifetime exemption means that a husband and wife can pass on to heirs up to $23.16 million exempt from estate taxes.
Some states offer certain citizens, such as seniors, the disabled and service veterans, a property tax exemption to help reduce the amount they owe. Some states offer a homestead exemption that in many cases completely eliminates their property tax burden.
A homestead exemption is often offered to seniors aged 65 and older. Some states tie the exemption to the property owner’s income. Unrelated to taxes, another form of homestead exemption protects a property owner from creditors’ claims and prevents them from selling a property to satisfy the owner’s debts if he or she lives there.
Other property tax exemptions that counties across the country offer are available to property owners who make home improvements, make their homes more energy efficient, are volunteer firefighters or are widowed.
What Does it Mean to Be a Tax-Exempt Organization?
A tax exempt organization is an entity whose income is not subject to tax. In general, any entity created to serve either the public or their specific members is exempt from taxes.
Examples of such organizations include churches that serve their congregations and charities established to serve specific segments of society, such as the sick, poor, or elderly.
- Credit unions
- Civic leagues
- Business leagues
- Social welfare organizations
- Labor, agricultural and horticultural organizations
- Social and recreation clubs
- Fraternal societies
- Teachers' retirement fund associations
- Mutual insurance companies
- Employee funded pension trusts
- Veterans' organizations
- Cooperative hospital service organizations
- Child care organizations
- Farmers' cooperative associations
The IRS requires a specific tax-exemption form for each status. Charitable, religious and educational organizations can apply for 501(c)(3) status using Form 1023; social welfare organizations can apply for 501(c)(4) status using Form 1024-A; and other nonprofit or tax-exempt organizations can apply for 501(a) status using Form 1024.
How Do Annuities Take Advantage of Tax Exemption?
Annuities purchased outside of a qualified retirement plan enjoy two important characteristics. The first is that their value can grow on a tax-deferred basis. The second is that only a portion of an annuity’s income stream is taxable.
Tax-deferral means that taxes won’t be due on gains until the investor actually starts drawing money from the annuity. When that happens, taxes will be due only on the earnings, which are just a portion of the annual income the annuity will provide.
Some of the income from an annuity will be a return of the original principal. There is no tax due on that portion. So, to a certain extent, an annuity does, indeed, provide income that is exempt from taxes.
12 Cited Research Articles
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- Internal Revenue Service. (2020, May 20). Applying for Tax Exempt Status. Retrieved from https://www.irs.gov/charities-non-profits/applying-for-tax-exempt-status
- Internal Revenue Service. (2020, April 15). Estate Tax. Retrieved from https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax
- Internal Revenue Service. (2020, June 29). Exempt Organization Types. Retrieved from https://www.irs.gov/charities-non-profits/exempt-organization-types
- Internal Revenue Service. (2020, February 28). Here’s a quick overview of tax reform changes and where taxpayers can find more info. Retrieved from https://www.irs.gov/newsroom/heres-a-quick-overview-of-tax-reform-changes-and-where-taxpayers-can-find-more-info
- Internal Revenue Service. (2020, January 28). Other Tax-Exempt Organizations. Retrieved from https://www.irs.gov/charities-non-profits/other-tax-exempt-organizations
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- Internal Revenue Service. (2019). Tax Reform Basics for Individuals and Families. Retrieved from https://www.irs.gov/pub/irs-pdf/p5307.pdf
- Internal Revenue Service. (2020, June 23). Topic No. 701 – Sale of Your Home. Retrieved from https://www.irs.gov/taxtopics/tc701
- Internal Revenue Service. (2020, April 15). What's New - Estate and Gift Tax. Retrieved from https://www.irs.gov/businesses/small-businesses-self-employed/whats-new-estate-and-gift-tax
- Byers, J. (n.d.). Property Taxes: A Look at Exemptions, Tax Limits and Assessment Cycles. Retrieved from https://www.naco.org/sites/default/files/documents/Property%20Taxes%20A%20Look%20at%20Exemptions,%20Tax%20Limits%20and%20Assessment%20Cycles.pdf
- Arnsberger, P. et al. (2008). A History of the Tax-Exempt Sector: An SOI Perspective. Retrieved from https://www.irs.gov/pub/irs-soi/tehistory.pdf
- West's Encyclopedia of American Law, edition 2. (2008). Homestead legal definition of homestead. Retrieved from https://legal-dictionary.thefreedictionary.com/homestead