What does tax exempt mean?
If an individual isn’t required by law to pay certain taxes, then they have a tax exemption. Tax exemptions are usually used to help relieve individuals financially if their income isn’t enough to make ends meet. This may apply to federal withholding amounts and income tax. Additionally, some businesses also qualify for tax exemptions.
However, tax exemptions don’t automatically apply to state and local income taxes. Medicare and Social Security taxes still apply and should be withheld from pay accordingly.
When you hire a new employee, they will fill out Form W-4, the Employee’s Withholding Certificate. This form indicates how much tax an employer should withhold from employee pay. Depending on what they qualify for, an individual can use different exemptions to reduce how much their income is taxed. In some cases, they may be eligible for a full tax exemption.
What is a withholding allowance?
Once an employee starts working for you and fills out the Form W-4, you’ll withhold a certain amount according to your tax obligations and allowances when completing payroll. This amount is based largely on the employee’s income level.
Some individuals may opt to withhold an additional amount to avoid owing to the Internal Revenue Service (IRS) or get a larger refund at the end of the tax year.
Who can claim tax exempt status?
According to the IRS, individuals must meet all of the following criteria to be eligible for tax exempt status:
- The employee must have had no tax liability for the previous year
- The employee must expect to have no tax liability for the current year
Other factors also determine eligibility for tax exempt status. Those who are claimed by other individuals as dependents may request an exemption if one of the following is true:
- The employee’s income will be less than $1,100
- The employee’s income will include more than $350 of unearned income, such as interests or dividends, and be less than $12,550
For others not claimed as dependents, tax withholding exemptions depend on their total annual income. As of 2021, the amount they earn must not exceed the limits listed below:
- $12,550 for single individuals
- $18,800 for a head of household
- $12,550 for married individuals filing separately
- $25,100 for married individuals filing jointly
- $25,100 for qualifying widowed individuals
Tax exemptions are generally applicable to:
- Students
- Foreign citizens
- Taxpayers with dependents
- Taxpayers with income deductions
- Dependents
- Low-income taxpayers
Individuals may refer to this guide from the IRS to help determine if they meet tax withholding eligibility criteria.
Form W-4 for tax exempt employees
If some of your staff members are exempt, they should indicate so on the Form W-4 once they begin working for your company. To claim exemption from withholding, your employees will follow these steps:
- Write “Exempt” on Form W-4 in the space below Step 4(c)
- Complete Steps 1(a), 1(b) and 5
- Leave the rest of the form blank
If an employee claims an exemption, the employer won’t withhold income tax from the employee’s paycheck.
On the other hand, if these employees don’t meet the criteria to qualify for exceptions when they file their next tax return, they may end up owing taxes and penalties. This form doesn’t need to be sent to the IRS, but they may request a hard copy for review. It should be kept in your records for at least four years to make sure you’ve withheld taxes according to the employee’s request.
What if there is an error, change or dispute with Form W-4?
If an employee’s personal or financial situation changes, they may be required to complete a new Form W-4. These changes include tax deduction eligibility, variations in salary or wage, and adding or removing dependents.
Unauthorized changes to Form W-4, such as defacement or adding form entries that were not requested, will make it invalid. The form is likewise invalid if the employee informs you that they’ve included any false information.
In these cases, employers should withhold taxes as if the employee were a single individual with no deductions or exemptions. If the employee had a previous W-4 form, you can use it to determine the amount to withhold until the employee provides you with a valid Form W-4.
Should the IRS have a dispute with the requested withholding amount, it may send both the employee and employer a lock-in letter, which will determine a new withholding agreement. The IRS allows the employee a period of time to dispute the new withholding amount before it takes effect.
When do employees need to resubmit Form W-4?
The Form W-4 does not expire, so employees don’t need to resubmit it. Exempt employees, however, need to provide a new Form W-4 by February 15 of the following year. If employees are expecting to owe federal tax the following year, they will complete a new form by December 1st of the current year.
