What is a Tax-Exempt Sector?

In investing, a tax-exempt sector is a group of financial instruments that pay tax-exempt interest. However, it also refers to nonprofit organizations, which are tax-exempt.

How Does a Tax-Exempt Sector Work?

Assume John Doe wants to lower his tax bill by investing in tax-exempt instruments. Instead of purchasing individual tax-exempt securities, he could invest in a mutual fund or ETF that invests in a variety of instruments in the tax-exempt sector. This allows John to diversify his investments but maintain a tax-free portfolio.

Charitable gifts to nonprofit organizations are often tax-deductible, and the organizations that receive those gifts usually do not have to pay taxes on those gifts (due to their tax-exempt status).

Why Does a Tax-Exempt Sector Matter?

Although investors subject to the alternative minimum tax may be required to pay taxes on instruments in the tax-exempt sector, tax-exempt interest means that many investors in high federal-tax brackets particularly benefit from investing in this sector.

As with most investments, investors in the tax-exempt sector are subject to credit, interest-rate, call, and market risk. However, many instruments in the tax-exempt sector, notably municipal bonds, are generally less risky than other instruments because their issuers are often more financially stable. This is primarily why, when combined with the tax advantages, the tax-exempt sector tends to have a correspondingly lower rate of return than the taxable sector.

Borrowers in the tax-exempt sector often have borrowing rates that may be more attractive than what is available through other means. This in turn encourages local governments and other tax-exempt entities to undertake new projects.