Bonds Primer: The Alternative Minimum Tax

If your tax bracket is such that municipal bonds make sense for you, you've got something else to consider: the alternative minimum tax.

The AMT was devised to keep the wealthy from deducting away entire tax bills. Who has to pay it? The rules are as follows: You calculate how much you would owe under the AMT, which charges lower rates but allows very few deductions. If that amount is larger than the amount of ordinary income tax you were going to pay, you have to pay the AMT instead of the ordinary income tax.

Everything that's taxable as ordinary income is taxable as AMT income, so this isn't an issue for bonds other than munis. It's an issue for municipals because some munis -- mainly airport bonds issued by airport authorities, and housing bonds issued by state or local housing authorities -- pay AMT-subject income.

That means that if you earn muni-bond income from AMT-subject bonds, you can't deduct it when calculating your AMT. As a result, earning AMT-subject income could turn you from an ordinary taxpayer into an AMT payer.

Only 0.8% of individual taxpayers are expected to be AMT filers in 1998. But they are expected to include 17.9% of people earning at least $200,000 a year. Most of the upper-middle-class people in New York state are candidates, says financial adviser Gary Ambrose of Personal Financial Management.

Inflation also causes more and more people to become subject to the AMT, since unlike the regular income tax, the various features of the AMT aren't indexed to inflation. By 2008, the percentage taxpayers who will file for the alternative minimum tax is forecast to balloon to 7.2%, including 42.7% of those earning more than $200,000.

If, on the other hand, you're sure you won't become subject to the AMT even if you own some AMT-subject munis (or a fund that invests in them, since the liability will pass through the fund to you), you might as well buy them.

Their yields are higher than the yields on regular munis, to compensate investors for the chance they might have to pay the tax. Historically, the yields of AMT-subject munis have been about 25 basis points, or hundredths of a percentage point, higher than those of regular munis.

Last year, more than three-quarters of the muni bond funds tracked by Lipper Analytical Services paid dividends that were at least partially subject to the AMT, with percentages of AMT-subject income ranging as high as 82%.

If you want to avoid the AMT, stay away from high-yield muni funds, virtually all of which hold AMT-subject bonds for their higher yields. Beyond that, note the name of the fund you're considering.

If it calls itself "tax-free" or "tax-exempt," the SEC requires that at least 80% of its assets or at least 80% of its income be exempt from all taxes. The balance can be subject to the AMT, or to regular income tax. If it only calls itself "municipal," any percentage of its assets may be taxable, as AMT income or as regular income.

To avoid the AMT altogether, consider a few funds and fund families that ban AMT bonds in their municipal portfolios. Among no-loads are American Century-Benham's various California funds (except the high-yield fund), Safeco's funds (except the Washington state fund), all of USAA's funds (1-800-382-8722) and the broker-sold Thornburg Intermediate Municipal fund.

U.S. Trust's no-load Excelsior funds (1-800-446-1012) are allowed to own AMT bonds, but because many of their investors are potential AMT payers, historically they have not done so.

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