You qualify for exemption from federal income tax withholding if you had no tax liability last year and expect none this year. This means you didn't owe any federal income tax, and you don't expect to owe any this year either.
When you claim exemption from withholding, your employer won't deduct federal income tax from your paycheck. However, this doesn't mean you won't owe taxes later. The IRS requires you to reassess your exemption status each year. If you claim exemption but end up owing taxes, you'll have to pay them when you file your tax return, plus potential penalties and interest.
There are two primary types of exemptions related to tax withholding:
Tax exemption from withholding is used primarily on the IRS Form W-4, which employees fill out to determine how much federal income tax should be withheld from their paychecks. If you qualify for exemption, you can indicate this on your W-4 form, and your employer will stop withholding federal income tax.
Many people confuse exemption from withholding with being entirely exempt from paying taxes. This is not the case. Even if you claim exemption from withholding, you may still owe taxes when you file your annual tax return. The exemption simply means you won't have taxes deducted from your paycheck during the year.
Another common misconception is that everyone can claim exemption from withholding. In reality, only those who meet the strict criteria-having no tax liability in the previous year and expecting none in the current year-can claim this exemption.
Let's say you're a part-time student earning $5,000 annually from a summer job. You had no federal income tax liability last year and expect to owe none this year. You can claim exemption from withholding on your W-4 form. Your employer will then withhold no federal income tax from your paychecks. However, when you file your tax return, you'll need to confirm that you had no tax liability. If you incorrectly claimed exemption and owe taxes, you'll face penalties and interest.