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.
Key Takeaways
- 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.
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 , 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 1.8 million corporations in various industries.
To become tax-exempt, a company must have a nonprofit purpose within designated categories recognized by tax authorities. The company must have a legal structure that qualifies, such as a nonprofit corporation, trust, or association. The application process involves submitting an application, providing supporting documentation, and paying fees.
Once a company is established as tax-exempt, companies must comply with regulations governing activities, fundraising, governance, financial transparency, and private benefits. The IRS determines if the company meets the requirements and receives an official determination letter confirming its tax-exempt status.
Advantages and Disadvantages of the Tax-Exempt Sector
Pros of the Tax-Exempt Sector
The tax-exempt sector was created for various reasons, many of which are meant to enhance society. Many of the benefits are below,
- Public Benefit: Nonprofit and other tax-exempt organizations prioritize advancing the general welfare, alleviating social needs, and enhancing local economies. They fund philanthropic organizations, advance research and education, and help the growth of society by offering necessary services.
- Philanthropy and Volunteerism: Tax-exempt organizations depend on philanthropic gifts and volunteerism from people, businesses, and foundations. Tax breaks for contributors promote charitable giving and aid charities in maintaining their financial viability. This allows greater opportunities for individuals that contribute to these entities to take tax deductions.
- Mission-Driven Approach: Without the burden of making money (i.e. for those that receive tax revenue as their primary funding source), many tax-exempt organizations can prioritize their mission and concentrate on achieving their organizational goals. As a result, they are better equipped to deal with pressing challenges, promote reform, and work toward long-term objectives for the common good.
- Innovation and Experimentation: In certain contexts, governments, nonprofits, and other tax-exempt entities are encouraged to solve societal problems. Nonprofits frequently investigate cutting-edge techniques, pilot projects, and creative solutions that would not be practical in sectors focused on making a profit.
Cons of Tax-Exempt Entities
Unfortunately, there some considerations for tax-exempt entities that make them less favorable in certain contexts. Some of those downsides are below.
- Limited Resources: Nonprofits may struggle with money problems and rely largely on donations, grants, and fundraising activities. Government entities often rely on tax revenue and competition with other governmental entities. In both cases, their ability to develop programs, attract qualified staff, or make investments in infrastructure and technology may be constrained by a lack of resources.
- Dependence on External Funding: Tax-exempt entities may be more susceptible to shifts in donor priorities, downturns in the economy, and variations in grant availability when they depend heavily on external funding sources. This may result in unstable finances and difficulties maintaining operations. Whereas for-profit entities may have greater control over financing, tax-exempt entities that are not able to generate revenue using various streams may be susceptible to greater financial risk.
- Compliance and Regulatory Burden: Tax-exempt entities are often subject to numerous rules, legal duties, and reporting requirements. It can be time-consuming and expensive to meet compliance regulations, which takes resources away from programming operations.
- Mission Drift: Because they operate differently than for-profit entities that must pay taxes, exempt organizations may find it difficult to strike a balance between maintaining their financial viability and pursuing their missions. There is a chance that organizations will stray from their primary goals and put financial concerns first.
Investing in Tax-Exempt Entities
Tax-exempt investments offer several benefits, though its main benefit is its namesake. As discussed throughout this article, income generated from tax-exempt investments is typically exempt from federal income taxes and state and local taxes. This results in higher after-tax returns compared to taxable investments.
These investments, particularly high-quality municipal bonds, are often issued by local governments or government agencies. Because of the credibility of these entities, investments in tax-exempt entities may provide greater stability and safety for investors seeking lower-risk income.
Last, the tax-exempt sector is quite different than for-profit, taxpaying entities. In many ways, owning investments in both tax-exempt entities and tax-paying entities exposes investors to different opportunities. Diversification in a well-diversified investment portfolio can help reduce overall risk and provide a counterbalance to other taxable investments, potentially reducing market volatility impact.
What Kinds of Organizations Are in the Tax-Exempt Sector?
According to the IRS, 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.
