What it is:
Generally, tax exempt means free from federal income taxation.
How it works (Example):
Tax exemptions can apply to a portion of an individual's income or to the nature of an organization.
For example, let's say that John purchases municipal bonds. The interest on those bonds is tax exempt, so John does not have to pay federal income taxes on that income. Income generated by investments in Roth IRAs is often tax exempt.
Likewise, nonprofit organizations are generally tax exempt, meaning that they are not required to pay federal income taxes on their income.
Why it Matters:
Tax exemptions obviously save taxpayers and organizations money on taxes. Accordingly, investments with tax exemptions can be very attractive, particularly to investors in high tax brackets or in economic environments in which taxes are high or expected to rise.
Considerable controversy exists regarding what sorts of income, activities, or organizations should be tax exempt. Most of the time, an organization has to be registered under section 501(c)(3) of the Internal Revenue Code in order to become tax exempt.
It is also important to note that even though income may be exempt from federal income taxes, the taxpayer or organization might still have to pay state, local, or other types of taxes (such as payroll taxes, sales taxes, or excise taxes).