Definition:
Tax-exempt gains are the profits distributed to investors in mutual funds that are not subject to federal taxes by the government. Typically, mutual funds that qualify for tax exemption are invested in municipal bonds, although some tax-exempt bonds may be issued by nonprofit organizations.
How do tax-exempt profit distributions work?
Generally, investors must pay taxes on investment profits, including distributed profits. However, profits distributed from certain types of mutual funds are exempt from federal taxation. These profits are known as exempt interest dividends.
Mutual funds that offer exempt interest dividends are typically invested, fully or partially, in municipal bonds. These bonds are not subject to federal taxes. In some cases, they may also not be subject to state taxes. Some nonprofit entities may also issue tax-exempt bonds.
State and local bonds have enjoyed tax exemption since the inception of the income tax in 1913. The federal government created the exemption to encourage local and state investment in infrastructure projects. Generally, municipal bonds are rated higher and considered safer than corporate bonds.
Therefore, mutual funds composed of municipal bonds are a popular investment among high-net-worth individuals who wish to reduce their federal tax liability on their assets, even though state and local bonds usually generate lower yield rates.
Examples of tax-exempt profits
Some examples of funds that may pay tax-exempt interest dividends include the Vanguard Massachusetts Tax-Exempt Fund (VMATX), which seeks to invest in securities exempt from federal personal income tax and Massachusetts tax. Another example is the Fidelity Conservative Income Municipal Bond Fund (FCRDX), which aims to invest at least 80% of its assets in local debt securities that are exempt from federal taxes.
Advantages and Disadvantages of Tax-Exempt Gains
Advantages:
- Beneficial in tax planning: High-net-worth individuals can use tax-exempt profits to reduce their tax burden.
- Reliable: Tax-exempt profits are generally considered reliable, and the underlying bonds are viewed as lower risk compared to other types such as corporate bonds.
Disadvantages:
- The need to report on tax returns: Although tax-exempt profits are not subject to taxation, investors still need to report them to the federal tax authorities.
- Lower yields than other investments: Since tax-exempt profits come from mutual funds composed of low-risk bonds, the returns you receive may be lower compared to investments in stocks.
What do tax-exempt profits mean for individual investors?
The benefit of tax-exempt profits is that they are typically not subject to federal income taxes. However, the mutual funds that pay such profits invest in securities that may provide a low yield rate.
You should also consider that these profits may be subject to state taxes or, in the case of high gains, the alternative minimum tax.
If you are interested in preserving your wealth rather than increasing it and have no concerns regarding the alternative minimum tax, you are likely to appreciate the low risk provided by mutual funds that offer tax-exempt profits.
Frequently Asked Questions (FAQs)
Do I need to report tax-exempt profits?
Yes, you must report tax-exempt profits to the federal tax authority even though in most cases you do not have to pay taxes on them.
What
What does tax-exempt interest mean?
In the context of mutual funds, tax-exempt interest refers to the fact that municipal bonds generate interest that is exempt from taxes for investors.
Source: https://www.thebalancemoney.com/what-is-an-exempt-interest-dividend-5215730
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