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.
- Tax-exempt sectors are either tax-exempt nonprofit organizations or market niches that comprise investment vehicles.
- Municipal bonds make up most of the investment vehicles in the tax-exempt sector.
- Munis usually have a lower yield than taxable bonds.
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.
The tax-exempt sector includes bonds, notes, leases, bond funds, mutual funds, trusts, and life insurance, among other investment vehicles.
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.)
What Kinds of Organizations Are in the Tax-Exempt Sector?
The tax-exempt sector consists of nonprofit organizations that don't pay federal taxes. According to the IRS, "organizations organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, educational, or other specified purposes and that meet certain other requirements are tax exempt under Internal Revenue Code Section 501(c)(3)."
What Types of Investments Does the Tax-Exempt Sector Include?
The tax-exempt sector comprises a wide range of investments, including bonds, leases, bond funds, mutual funds, life insurance, Coverdell Education Savings Account distributions, health savings account (HSA) distributions, and fixed annuities. However, municipal bonds, or munis, make up most of the investments in this sector. They are also the most familiar tax-exempt investment. States and localities, which raise money for costly public projects such as roads, schools, and hospitals rely on munis to fund them. These investments are exempt from federal taxes because U.S. regulation forbids the federal government from taxing debt assets offered by local and state government agencies.
What Is the Yield on Municipal Bonds vs. Taxable Bonds?
Municipal bonds tend to have a lower yield because of their tax-exempt status. And most pay no interest until maturity, or they carry interest at either a fixed or variable rate. The repayment period can range from a few months to 30 years or even longer.
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.