Exemptions to the Income Tax, or What Don’t We Tax?
The income tax takes a portion of a person’s total income in tax for the government, but there are important exemptions to this that allow a person to minimize how much it is that the government takes. The exemptions are grounded in practicality and fairness reasons, acknowledging that people cannot pay taxes with money they already have and exempting from taxes things like personal injury payouts, because such payments aren’t income but rather compensation for something lost.
The exemptions from taxation for specific uses serve a different purpose. By encouraging people to save their money, the government shifts the tax from a general income tax to a consumption tax. With these exemptions, people are taxed on wealth when they are spending it. These exemptions focus the tax on the consumption of wealth for people with un-exempted incomes.
Sources
Unrealized Gains
Unrealized gains are the increase in value of capital that has not yet been sold. These gains cannot be taxed until the capital is sold, creating a “ticking tax time-bomb.” This makes sense, because they do not result in an increased amount of money on hand (if they did, they wouldn’t be unrealized) and may lose value in the future.
Many people gained value in their houses from 2000-2008; theoretically, the government could have charged them taxes every year for the increase in their wealth. But then a lot of those gains were wiped out when the housing market crashed at the end of 2008. It is easy to understand why it would be unfair for the government to charge taxes as the value increased; people may not have been able to afford the taxes since the increased wealth wasn’t increased money and when the property eventually lost value, they would have paid taxes for wealth they never received.
When capital that has successfully appreciated is then sold, that increase in value becomes realized and is capital gains, discussed in What Do We Tax?
Inheritance
It turns out, taxes put the fun in funeral, for two reasons. First, the recipient of the inheritance is never taxed on their newfound wealth. Second, the unrealized gains are reset (stepped-up in basis) so that there is no built-in tax to any capital that is inherited. (In some circumstances, the decedent is taxed, but this is exceedingly rare and easily avoided, so it is not even worth explaining.)
The first wonderful thing means that you never have to pay taxes on the money you’ve inherited. It also means that the family home doesn’t have to be sold to pay off your new tax bill.
The second wonderful thing is even better. Resetting unrealized gains means that, at the time of your inheritance: there are no gains! Your grandparents may have spent $1 million on their house in 1970 and that house is worth $4 million at the time of their death, when you inherit it. If they had sold it before they died, they would have had to pay capital gains taxes on the $3 million increase in value.
$4 million at sale - $1 million at purchase = $3 million taxable gains
Instead, when you eventually sell it for $6 million, you only have to pay capital gains taxes on $2 million! This is because, when you inherited it, the change in value was reset to its value at that time and gains start accumulating anew.
$6 million value at sale - $4 million value at inheritance = $2 million taxable gains
This makes for easier bookkeeping, and it provides for the perfect loophole from taxation. If you’re having trouble grasping how this loophole works, check out Tax Planning 101: Buy, Borrow, Die.
Uses
Retirement Savings
Taxes can be deferred for up to $19,000 that is saved through qualified means. That means that money is deductible from your taxes this year but taxes must be paid on the full amount when they are sold. This is especially useful for shifting income into a time where you will be taxed in a lower tax bracket and is done to encourage people to save for retirement.
If you have an income of $100,000 and put $10,000 into your retirement savings, then this year you will be taxed based on a salary of $90,000.
($100,000 income - 10,000 tax-exempt retirement contribution = $90,000 taxable income
When you are retired and finally take that $10,000 out to pay for your groceries and gas, it will be taxed as $10,000 earned that year of withdrawal. Typically, this means you will be in a lower tax bracket (because you no longer have a full salary) and thus pay a lower percentage in taxes.
(Some) Business Investments
Business investments are similar to retirement savings. Qualified business investments are deferred from taxes until the investment is sold. Depending on the type of investment, the entire investment can be deferred immediately, the investment can be deferred year-by-year, or the investment can be taxed immediately and treated as capital gains.
Employer-Provided Health Insurance
Money that is used for health insurance through an employer and some medical expenses are deductible. This means that no taxes are paid on this money; your “income” for the purposes of taxation is lowered by this amount. If you have an income of $100,000 and spend $10,000 on your health insurance, you will be taxed based on a salary of $90,000. This reflects the fact that we don’t really think of medical expenses as taxable spending because of their necessity.
Other People’s Money
Taking out debt does not, from an economic perspective, create wealth. This makes sense; a loan of $1,000 gives you cash but means that you owe the lender that back, plus interest. Paying off debt, however; if you have paid off $100 of your loan, then you only owe the lender $900 (it has increased your net worth). Taking out debt is not taxed. Paying off debt is not usually an exempted form of savings. That means that post-tax dollars are used to pay off debt, so the debt is typically taxed when it is paid back and not when it is taken out.
Next: Read How Much Is Taxed?