Can You Exempt Federal Taxes & Reduce Your Tax Bill?

Federal taxes are levies by the U.S. government on individuals and entities. Federal income tax is the most common and largest source of government revenue, imposed on annual earnings like wages, salaries, business income, and investments. The U.S. employs a progressive tax system, where higher income levels are subject to higher tax rates. Other federal taxes include employment taxes for Social Security and Medicare, and taxes on gifts or estates.

For individuals, “exempting” federal taxes means legally reducing the amount of income subject to taxation or directly lowering the tax owed. The Internal Revenue Service (IRS) provides various provisions within the tax code that allow taxpayers to achieve this reduction. These legal strategies can lower one’s overall federal tax burden.

Understanding What Income Is Taxed

Taxable income includes all income from any source, unless specifically excluded by law. This encompasses wages, salaries, tips, bonuses, and commissions received from employment. Other forms of taxable income include interest earned on bank accounts, dividends from stocks, capital gains from selling assets like real estate or investments, and income from a business or rental properties. Unemployment compensation and lottery winnings are also subject to federal income tax.

Certain types of income are not included in gross income for federal tax purposes. These include:

• Interest from municipal bonds issued by state or local governments
• Life insurance proceeds paid to a beneficiary due to the insured’s death
• Gifts and inheritances received by the recipient, though the giver may be subject to gift or estate taxes
• Qualified employer-provided fringe benefits, such as health insurance premiums
• Certain welfare benefits

Reducing Your Taxable Income Through Deductions

Deductions serve to reduce an individual’s taxable income, thereby lowering the amount of income on which federal tax is calculated. Taxpayers choose between taking a standard deduction or itemizing their deductions, selecting the option that results in the larger reduction. The standard deduction is a fixed dollar amount that varies based on filing status, such as single, married filing jointly, or head of household. This amount is adjusted annually for inflation and simplifies tax filing for many.

Alternatively, taxpayers can itemize deductions if their eligible expenses exceed the standard deduction amount. Itemized deductions include:

• State and local taxes (SALT), which are capped at $10,000 per household
• Home mortgage interest paid on a primary or secondary residence
• Charitable contributions made to qualified organizations
• Medical expenses exceeding 7.5% of adjusted gross income (AGI)

Beyond itemized deductions, some deductions are “above-the-line,” meaning they reduce gross income to arrive at adjusted gross income (AGI) regardless of whether a taxpayer itemizes. These include:

• Contributions to a traditional Individual Retirement Account (IRA), subject to income limitations and participation in an employer-sponsored retirement plan
• Student loan interest paid, up to a certain annual limit
• Contributions to a Health Savings Account (HSA)

Direct Tax Reductions Through Credits

Tax credits directly reduce the amount of federal tax owed, dollar for dollar. Credits are categorized as either refundable or non-refundable, with different implications for a taxpayer’s final tax liability.

Non-refundable credits can reduce a tax liability to zero, but they do not result in a refund if the credit amount exceeds the tax owed. The American Opportunity Tax Credit, which helps offset higher education expenses, is a non-refundable credit, though a portion can be refundable for some taxpayers. The Lifetime Learning Credit, another education credit, is entirely non-refundable.

Refundable credits, conversely, can reduce a tax liability below zero, resulting in a tax refund even if no tax was originally owed. These include:

• The Earned Income Tax Credit (EITC) designed for low-to-moderate income working individuals and families
• The Child Tax Credit (CTC), with a portion of it being refundable, allowing eligible families to receive a refund even if they owe no tax
• The Child and Dependent Care Credit, which helps offset expenses paid for the care of a qualifying child or dependent to allow the taxpayer to work or look for work

Leveraging Tax-Advantaged Accounts

Tax-advantaged accounts offer benefits that can exempt income from current taxation, allow for tax-deferred growth, or permit tax-free withdrawals under certain conditions. These accounts are designed to encourage long-term savings for purposes, such as retirement or education. Contributions to traditional 401(k)s and traditional Individual Retirement Accounts (IRAs) are tax-deductible, reducing current taxable income. The investments within these accounts grow on a tax-deferred basis, meaning no taxes are paid on earnings until withdrawal in retirement.

Roth IRAs and Roth 401(k)s operate differently; contributions are made with after-tax dollars, so they are not tax-deductible. However, qualified withdrawals in retirement, including all earnings, are completely tax-free. This provides a benefit by exempting future investment gains from taxation. Both traditional and Roth retirement accounts allow investment growth to compound without annual taxation.

Health Savings Accounts (HSAs) offer a “triple tax advantage.” Contributions to an HSA are tax-deductible, the funds grow tax-free, and qualified withdrawals for medical expenses are also tax-free. These accounts are available to individuals enrolled in a high-deductible health plan. For education savings, 529 plans allow for tax-free growth of investments and tax-free withdrawals when used for qualified education expenses, such as tuition and fees. These accounts provide tools for reducing tax burdens over time.