Your Funds Might Be Exposed to the AMT

Be careful your bond funds' yield isn't being eaten away.
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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) - Get Report

Limited Term Municipal Fund (LTMFX) and the

(THNYX) - Get Report

New York Intermediate Municipal Fund (THNYX).

Vanguard

has stopped investing in private-activity bonds in thirteen of its municipal bond funds. They are the

Vanguard MA Tax-Exempt Fund (VMATX)

Vanguard OH LT Tax-Exempt Fund (VOHIX)

Vanguard NJ Long-Term Tax-Exempt Fund (VNJTX)

Vanguard NY Long-Term Tax-Exempt Fund (VNYTX)

Vanguard PA Long-Term Tax-Exempt Fund (VPAIX)

Vanguard CA Long-Term Tax-Exempt Fund (VCITX)

Vanguard CA Inter-Term Tax-Exempt Fund (VCAIX)

Vanguard FL Long-Term Tax-Exempt Fund (VFLTX)

Vanguard Ltd.-Term Tax-Exempt Fund (VMLTX)

Vanguard Short-Term Tax-Exempt Fund (VWSTX)

Vanguard Inter-Term Tax-Exempt Fund (VWITX)

Vanguard Long-Term Tax-Exempt Fund (VWLTX)

Vanguard Insured LT Tax-Exempt Fund (VILPX)

Because the sale of the AMT bonds was completed early this year, customers who are subject to this tax may still have some reportable income from these funds on their 2007 returns.

The

(VWAHX) - Get Report

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