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.

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