How Claiming an Exemption Affects Your Tax Refund

Americans have been grappling with the issue of taxes – and trying to figure out how to avoid paying too much of them – since colonists dumped all that tea into Boston Harbor in 1773. The U.S. government proved to be a bit kinder than the English Parliament, introducing the concept of tax exemptions during the Civil War.

Tip

Exemptions are like tax gifts. The more you can claim, the less you’ll have to pay Uncle Sam.

What Are Tax Exemptions?

Tax return exemptions are amounts of money you’re permitted to subtract from your taxable income as you prepare your return. Here’s a tax exemption example in very basic terms: You earned $45,000 last year. You’re entitled to claim a $2,000 exemption. Now you only have to pay taxes on $43,000 in income.

Technically, any tax deduction is an exemption. There are three kinds: itemized deductions, the standard deduction and above-the-line adjustments to income.

Unfortunately, you can’t claim both itemized deductions and the standard deduction. You must choose between these options at tax time, so it only makes sense to claim the one that results in a larger overall exemption when you add up all your qualifying itemized expenses. But you can claim adjustments to income in addition to itemizing or claiming the standard deduction.

The Tax Exempt Definition Is Slightly Different

The term “tax-exempt” relates to sources of income that aren’t taxable and legal entities that aren’t subject to taxation, such as churches and certain charities. It’s slightly different from “tax exemption.” One refers to income and the other refers to deductions you can take from income.

Tax-exempt income sources include things like the value of health insurance provided by your employer, life insurance proceeds and inheritances.

What Are Withholding Allowances?

Exemptions go hand-in-hand with the allowances you claim on the W-4 form you submit to your employer. Your employer bases the amount of tax withheld from each of your paychecks – and subsequently forwarded to the IRS on your behalf – on the information you include on this tax form, including your filing status and the number of allowances you want to claim.

The more allowances you claim, the less money is deducted from your pay and sent to the IRS. You can claim up to two allowances if you’re single and working just one job. You can claim up to three allowances if you’re married, filing jointly, and you – but not your spouse – work one job. Things get trickier if you have kids. Now your available allowances are based on your income, but the IRS provides instructions and a worksheet online to help you figure it out.

So what happens if you claim too many or too few allowances? You’ll notice the effect at tax time. If you claim too many, you’ll find that not enough money was withheld from your pay so you’ll owe the IRS. You might even owe an underpayment penalty.

The Effect of Exemptions on Refunds

Obviously, it’s better to claim too few allowances than too many, but this isn’t ideal either. You’re effectively using the IRS as a savings account when you claim fewer allowances than you have to. Too much in the way of tax is withheld from your pay.

You – and the IRS – will realize that you overpaid when you complete and file your tax return. The IRS will obligingly send you a refund for the amount you overpaid. You’ll get that money back, but the IRS doesn’t pay interest. It gets to use your money for the year, then just give it back to you. Your money would be better off sitting in even a low-interest savings account.

Available Tax Exemptions in 2018

The Tax Cuts and Jobs Act turned the issue of tax exemptions upside down and inside out when it went into effect in January 2018. Many exemptions that used to be available are gone now, at least until the law expires at the end of 2025. But a good many remain, and one got better.

Standard deductions for every filing status pretty much doubled under the new law. They’re now set at $12,000 for single filers and those who are married but file separate returns, at $18,000 for head of household filers and $24,000 for married taxpayers filing jointly and qualifying widow(er)s. Those who are over age 65 or blind can deduct an additional $1,300, or $1,600 if you’re married and both spouses qualify.

As a result, you’ll need more deductible expenses in 2018 than these amounts to justify itemizing. Otherwise, you’d be paying taxes on more income than necessary, and the IRS won’t send you a refund if you goof in this respect.

Itemized tax exemptions you might possibly claim in 2018 include charitable contributions, state and local property or sales taxes and medical expenses that exceed 7.5 percent of your adjusted gross income. Employer-provided health insurance, life insurance death benefits and inheritances continue to be tax-exempt sources of income. If you invest in municipal bonds, any interest they kick off remains tax exempt as well.

State and local property tax or sales tax deductions are capped at $10,000 collectively in 2018. The limit is just $5,000 if you’re married and file a separate tax return.

Exemptions That Went Away After 2017

The new tax law repealed the personal exemptions that were once available to taxpayers, and these were really good exemptions – $4,050 per person in the 2017 tax year. That worked out to a total reduction in taxable income of $16,200 for married taxpayers with two child dependents, or any other family of four. Personal exemptions were available in addition to the standard deduction or the total of your itemized deductions.

Another significant change is how alimony is treated for tax purposes. It used to be that the spouse paying it could claim the annual amount as an adjustment to income, and the receiving spouse would have to declare it and pay taxes on it as income. Not anymore, at least not after Dec. 31, 2018.

You used to be able to claim an itemized deduction for interest you paid on most home equity loans, but this exemption has been eliminated as well. You can still claim it for acquisition loans such as first mortgages, however. And the itemized employee business expense deduction is gone now as well, along with the above-the-line adjustment to income for moving expenses prompted by a change in employment. Casualty and theft itemized deductions can only be claimed now if they come about due to an event that’s been declared a disaster by the president.

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About the Author

Beverly Bird has been writing professionally for over 30 years. She specializes in personal finance and w, bankruptcy, and she writes as the tax expert for The Balance.


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