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Your Funds Might Be Exposed to the AMT

Travis Altman

Editor's note: As a special feature for March, TheStreet.com is offering an ongoing series on everything you need to know about taxes. Today is part 14.

You can run from the Alternative Minimum Tax, but it may be difficult to hide. More investors are finding out some income earned from tax-free municipal bond funds can count against them when calculating the AMT.

The AMT was introduced in 1969 to stop rich people from using loopholes and deductions to avoid paying any taxes. Unfortunately, the brackets for this parallel tax system weren't indexed to inflation. Nearly four decades later, many middle-class Americans are getting caught up in the dragnet. The Congressional Budget Office estimates one in five taxpayers could be affected by the AMT by 2010.

The AMT became an issue for municipal bond fund investors in 1986, when the IRS started making distinctions between municipal bonds used for public and private purposes. Some bonds used to fund airports, housing and other types of development projects became classified as private-activity -- taxable under the AMT.

Josh Gonze, a co-portfolio manager for Thornburg Investments, says it's an example of "taxation run amok" that can take a big bite out of returns. If a municipal bond fund normally yields 5%, and 25% of its portfolio consists of bonds with AMT exposure, you could end up with an actual yield of just 4.65% after taxes. "We fight for every basis point in this business," Gonze says. "So a fund like that would be considered a poor performer."

Two of Thornburg's five municipal bond funds hold no AMT bonds -- the (LTMFX Quote)Limited Term Municipal Fund (LTMFX) and the (THNYX Quote)New York Intermediate Municipal Fund (THNYX). Vanguard has stopped investing in private-activity bonds in thirteen of its municipal bond funds. They are the

The (VWAHX Quote)Vanguard High Yield Tax-Exempt Fund (VWAHX) and all of its tax-free money market funds will continue to invest in private-activity bonds.

Fidelity fund manager Christine Thompson says her firm will continue to offer municipal bond funds with varying degrees of AMT exposure. Private-activity bonds have traditionally used higher yields to attract investors. Thompson says they can sometimes "offer wonderful potential" but at the moment "spreads are so tight, you are not getting paid for AMT."

As more Americans find themselves subject to the Alternative Minimum Tax, you can be sure the outcry against it will grow. However, because the AMT generates billions of dollars in tax revenue, change won't come overnight. Investors considering municipal bond funds will probably have to get used to the idea of considering tax implications as they make their decisions.

Below is a list of closed-end funds tracked by TheStreet.com Ratings with at least 20% of their holdings in municipal bonds subject to the AMT.

Next in the tax series: Tax Freedom Day