Your Funds Might Be Exposed to the AMT

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."