Tax-Exempt Sector

What Is the Tax-Exempt Sector?

The tax-exempt sector can refer to either a market niche comprising investment vehicles or nonprofit organizations that are exempt from federal taxes.

The term is most often associated with 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 Account distributions, health savings account (HSA) distributions, and fixed annuities.

The majority of investment vehicles in the tax-exempt sector are municipal bonds; 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.

Municipal bonds, or munis, are the most widely known tax-exempt investment. The municipal bond market allows local and state governments to issue bonds that raise funds to pay for various projects. Most munis are tax-free, but the tax status is subject to how the bonds are used. In addition, several munis and other tax-exempt investments offer lower returns than taxable investments. (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 compared with taxable bonds because of the tax-exempt status.

The interest paid varies by state and purpose. If an investor purchases bonds issued in their state, the interest is free from state income taxes. Munis lower the risk of default and in a portfolio can often soften the impact of stock market volatility.

Types of Tax-Exempt Bonds

There are two types of tax-exempt municipal bonds, classified by how the money borrowed is repaid: general obligation (GO) bonds and revenue bonds.

Government municipal bond issuers offer a guarantee, since the taxing authority typically raises funds to repay any GO bond obligations. Revenues derived from tolls, rents, or expenses from infrastructure 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 rate. Repayment periods range from a few months to 30 years or longer. An independent rating agency determines the likelihood of municipal bond repayment and, for general purposes, the quality of the bond. The three primary muni bond-rating agencies in the U.S. are Standard & Poor's, Fitch, and Moody's.

Tax-Exempt Organizations and Corporations

The tax-exempt sector also refers to nonprofits that do not pay federal taxes. These organizations are required to file specific documents with the Internal Revenue Service (IRS), which you can check. The tax-exempt sector, as defined by the IRS, includes more than 1.7 million corporations in various industries.

(Charitable contributions to qualified nonprofits may be tax-deductible.)

The Bottom Line

The tax-exempt sector can refer to either a market niche comprising investment vehicles or nonprofit organizations. With regard to the former, the sector includes many varied types of investments, and can be a dependable part of any portfolio. Check with an investment advisor or tax expert if you have questions.