Municipal Bonds And The Alternative Minimum Tax

Municipal Bonds are known to be tax advanaged vehicles for investing money, but that tax advantage sometimes does not extend to individuals subject to the Alternative Minimum Tax (AMT).

The AMT was originally created to prevent millionairres from using deductions and other accounting tricks to avoid paying income taxes. It does this by in essence, creating a seperate tax code with its own rules and less generous deductions. When the AMT was first created in the 1970s, it only applied to a few thousand indivuals with high incomes but because it is not indexed to inflation, it now applies to millions of people.

A brief issued by the Congressional Budget Office (CBO) (No. 4, April 15, 2004), concludes:

"Over the coming decade, a growing number of taxpayers will become liable for the AMT. In 2010, if nothing is changed, one in five taxpayers will have AMT liability and nearly every married taxpayer with income between $100,000 and $500,000 will owe the alternative tax. Rather than affecting only high-income taxpayers who would otherwise pay no tax, the AMT has extended its reach to many upper-middle-income households. As an increasing number of taxpayers incur the AMT, pressures to reduce or eliminate the tax are likely to grow."

How this Impacts Municipal Bonds

Amongst the many items that can no longer be deducated in the AMT include interest on private activity municipal bonds. These bonds arevtypically municipal bonds that are issued to fund private projects like sports stadiums and hospitals as opposed to public projectsl like schools, roadwork, sewer systems, etc.

While it's easier to recognize and spot a private activity munis when purchasing individual bonds, this becomes much harder when purchasing a municipal bonds mutual fund or a muni etf where many different bonds are packaged together.

In response to this, many financial companies have created AMT free funds and ETFs. They generally pay a lower rate but remove any chance of the revenue qualifying as income under the AMT.

If you are unsure about your AMT status or the AMY status of a certain fund or ETF, be sure to consult your tax or investment advisor.