What is Tax Exempt?

Generally, tax exempt means free from federal income taxation.

How Does Tax Exempt Work?

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 Does Tax Exempt Matter?

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).

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Paul Tracy
Paul Tracy

Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.