DEFINITION of 'Tax-Exempt Sector'

The tax-exempt sector is the market that contains investment vehicles exempt from federal taxes. The majority of investments in this sector are municipal bonds, which cannot be taxed because U.S. regulation forbids the federal government from taxing debt assets offered by local and state government agencies. These tax exemptions offer investors incentives to purchase low-yield government bonds rather than higher-yielding corporate fixed-income securities.

BREAKING DOWN 'Tax-Exempt Sector'

A tax-exempt sector is a set of investments that pays tax-exempt interest or dividends. The sector includes bonds, notes, leases, bond funds, mutual funds, money market funds, trusts, life insurance, ROTH IRA earned income, Coverdell Education Savings Accounts, health savings accounts and fixed annuities.

The tax-exempt sector also refers to nonprofits that do not pay federal taxes. Charitable contributions to nonprofits may be tax-deductible. These organizations are required to file specific documents with the Internal Revenue Service. The tax-exempt sector as defined by the IRS includes over a million corporations in various industries.

Municipal bonds, or munis, are the most widely known tax-exempt investment. Most munis are tax-free. However, the tax status is subject to how the bonds are utilized. In addition, several munis and other tax-exempt investments offer lower returns than taxable investments. The municipal bond market allows local and state governments to issue bonds to raise funds to pay for various projects. Bonds issued in this sector are not subject to federal income taxes. In addition, several municipal bonds, as well as other nontaxable investments such as Treasury bills, notes and bonds, offer lower returns than taxable investments. However, Treasury bills, notes and bonds are subject to federal income tax.

What Are Municipal Bonds?

Municipal bonds are debt assets issued by municipalities, states, airports, school districts and other public entities to fund public projects such as schools, highways, water systems, energy utilities, public housing and hospitals. Munis usually have a lower yield as opposed to taxable bonds because of the tax-exempt status. The interest paid varies by state and purpose. If an investor purchases bonds issued in his state, the interest is free from state income taxes. Munis lower the risk of default and shield the impact of stock market volatility by providing higher returns than most other asset classes.

Types of Tax-Exempt Bonds

There are two types of tax-exempt municipal bonds classified by how the money borrowed is repaid: general obligation bonds and revenue bonds. Government municipal bond issuers offer a guarantee since the taxing authority typically raises funds to repay any bond obligations. Revenues derived from tolls, rents or expenses from infrastructures back revenue bonds and are used solely to repay revenue bond obligations.

Municipal Bond Issuers

Most munis pay no interest until maturity or carry interest at either a fixed or variable interest rate. Repayment periods range from a few months to 30 years or longer. An independent rating agency decides the likelihood of municipal bond repayment. In the United States, the three primary muni bond-rating agencies are Standard & Poor's, Fitch and Moody's.

RELATED TERMS
  1. Tax-Exempt Security

    A security in which the income produced is free from federal, ...
  2. Taxable Municipal Bond

    A fixed-income security issued by a local government such as ...
  3. Tax-Exempt Interest

    Interest income that is not subject to federal income tax. Tax-exempt ...
  4. Double Exempt

    The status accorded to municipal bonds for which interest is ...
  5. Municipal Bond

    A debt security issued by a state, municipality or county to ...
  6. After-Tax Basis

    A comparison of the net yields produced by taxable and tax-exempt ...
Related Articles
  1. Investing

    A Look at the Pros and Cons of Muni Bonds

    Considering muni bonds? Here's a look at their pros and cons.
  2. Investing

    What's a Tax-Efficient Investment for a Large Sum?

    Here's how to invest a large sum, such as assets from a profit-sharing plan, with a mind toward tax efficiency.
  3. Investing

    The Basics Of Municipal Bonds

    Investing in these bonds may offer a tax-free income stream but they are not without risks.
  4. Financial Advisor

    How to Find the Best Bets in Muni Bonds

    Approach investing in municipal bonds the same as you would investing in stocks.
  5. Investing

    Avoid Tricky Tax Issues On Municipal Bonds

    Learn the rules every investor should know before buying into this "tax-free" investment.
  6. Investing

    5 Reasons to Invest in Municipal Bonds When the Fed Hikes Rates

    Discover five reasons why investing in municipal bonds after the Fed hikes interest rates, and not before, can be a great way to boost investment income.
  7. Financial Advisor

    The 6 Most Liquid Muni Bond ETFs (MUB,SHM,TFI,ITM)

    Looking for safety in an uncertain world? Consider these liquid muni bond ETFs.
  8. Investing

    Why Muni Bonds and Bond Funds are Perfect Together

    Municipal bonds and bond funds differ in several ways, which is partly why they complement each other well.
  9. Investing

    How To Choose The Right Bond For You

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
RELATED FAQS
  1. What do cities do with the funds generated from municipal bonds?

    Learn more about municipal bonds, including the various types of bonds issued and the purposes of municipal bond funds, such ... Read Answer >>
  2. What is the difference between municipal bonds and standard money market funds?

    The primary difference between municipal bonds - also known as "munis" - and money market funds is that municipal bonds are ... Read Answer >>
  3. Where can I buy government bonds?

    The type of bond determines where you can purchase it, so you need to decide which type of bond you would like to purchase ... Read Answer >>
  4. Who or what is backing municipal bonds?

    Learn about the basics of municipal bonds, including the various revenue sources that are utilized to back or secure municipal ... Read Answer >>
  5. How do the returns on municipal bonds compare to those of other bonds?

    Learn how tax-free municipal bonds may provide better returns than other types of bonds, and understand the risks of municipal ... Read Answer >>
Hot Definitions
  1. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  2. Money Market

    A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. ...
  3. Block (Bitcoin Block)

    Blocks are files where data pertaining to the Bitcoin network is permanently recorded.
  4. Fintech

    Fintech is a portmanteau of financial technology that describes an emerging financial services sector in the 21st century.
  5. Ex-Dividend

    A classification of trading shares when a declared dividend belongs to the seller rather than the buyer. A stock will be ...
  6. Debt Security

    Any debt instrument that can be bought or sold between two parties and has basic terms defined, such as notional amount (amount ...
Trading Center