An AMT Overview
What has been dubbed taxpayer enemy No. 1? The IRS’s National Taxpayer Advocate says it’s the Alternative Minimum Tax (AMT). The AMT was originally created in 1969 to prevent taxpayers in the highest income tax brackets from avoiding federal income tax altogether through abuse of exemptions and deductions; it’s a separate tax computation that eliminates many of these deductions and exemptions and counts interest received from certain tax-exempt bonds as taxable income.
Who’s Affected by the Alternative Minimum Tax?
AMT affects primarily those taxpayers who receive significant deductions or income from sources other than ordinary earned income — sources such as capital gains, interest or dividend income, employee benefits, and stock options. Retirees with large proportions of investment and pension income are classic examples of AMT taxpayers. Through a phenomenon known as bracket creep, however, more and more middle-class taxpayers have become subject to the AMT, a tax originally intended to target only the very wealthy.
Part of the reason for this is that AMT rates and exemptions are not indexed for inflation or income growth, but taxpayer’s income continues to rise. As these taxpayers’ state and local taxes rise along with their incomes, the itemized deductions of those taxes contributes to the number of AMT preference items (see explanation below), making the taxpayer subject to the AMT. Millions of upper-middle class taxpayers — contrary to the intent of the drafters of the original bill — have thus become subject to the tax in recent years.
Increasing Numbers of AMT Taxpayers Are a Result of Recent Trends and Legislation
The alternative compensation stock option boom of the 1990s contributed to the growing number of taxpayers subject to the tax, since paper profits from the exercise of stock options are subject to AMT (unless shares are sold before December 31 of the year the options were exercised). Through this growth, AMT affected nearly four million individual returns for tax-year 2007. For high-income individuals, of course, the AMT has become commonplace.
Prior to the 2001 tax-cut bill, the AMT was projected to affect 17 million taxpayers by 2010. Updated projections now indicate that AMT will affect 27 million people in 2010 and 51 million in 2020. Why the dramatic rise? The bill, which lowered marginal rates while leaving the AMT provisions unchanged, will accelerate bracket creep through a reduction in regular federal tax liability — to the point at which the AMT payment becomes mandatory.
How is The Municipal Bond Market Affected by AMT?
AMT legislation requires that numerous taxpayer deductions, exemptions, and certain forms of tax-exempt income be dubbed as preference items — to be treated as taxable income. One of those preference items is interest on private-purpose municipal bonds (other than qualified 501(c)(3) bonds) issued after August 7, 1986. (The Tax Reform Act of 1986 called for tax-exempt bonds to be classified into two categories: private-purpose and public-purpose.) Most so-called project bonds — those issued to fund housing, student loans, airports, and industrial projects—are classified as private-purpose bonds. The private versus public distinction is critical to those who may be subject to the AMT. Private-purpose AMT bonds have little appeal to an investor who faces the tax for even a short period, since he or she may be subject to either a 26% (on the first $175,000 of income) or 28% tax (on all income over $175,000) on the interest income.
Implications of AMT for Muni Bond Fund Investors
Many municipal bond funds hold sizeable proportions of private-purpose bonds, which means they distribute AMT-subject income to their shareholders; some municipal bond funds hold more than 25% of the portfolio in bonds that pay interest subject to the tax. AMT bonds are issued with a certain discount attached, as those issuers understand that investors demand to be paid higher yield in return for the possibility of being subject to tax. Some managers, therefore, attempt to capture that extra bit of yield. It’s important to note, however, that AMT municipal bonds typically pay only 15 to 20 basis points over comparable non-AMT bonds. This is certainly not adequate compensation for the 28% tax bite an investor may face.
To determine what percentage of a municipal bond fund's distribution is subject to AMT, check the fund's tax information brochure, search the fund company's website, call the customer service line, or check Morningstar Principia Pro software. Morningstar asks fund companies to disclose the average proportion of AMT bonds, but not every manager responds. Municipal bond funds are also required to distinguish between AMT and non-AMT income on annual tax forms mailed to shareholders. Select mutual fund companies market some municipal funds as nearly or completely AMT-free.
Thornburg Limited Term Municipal Fund (LTMFX) and Thornburg New York Intermediate Municipal Fund (THNYX), for example, typically hold 0% AMT bonds. Other Thornburg municipal bond funds hold less than 15% AMT paper, as a rule.
Keep in mind that municipal bond funds that avoid AMT bonds are likely to sacrifice some yield (again, 10 to 20 basis points) as compared to those that invest in AMT paper.
Freedom from a potential 28% tax bite more than compensates — for most investors — for the loss of a few basis points in yield.
This article does not intend to provide tax advice. Prospective investors are urged to consult a tax advisor for personal tax questions and concerns.
Maximum sales charge for the class A shares of the Thornburg Limited Term Municipal Bond Funds is 1.50%; maximum sales charge for the class A shares of the Thornburg Intermediate Term Municipal Bond Funds is 2.00%.
Shares in the fund carry risks including possible loss of principal.
Short-term bonds will fluctuate relative to changes in interest rates. The principal value of a bond fund will decrease when interest rates rise. Share prices and returns will fluctuate and investors may experience a loss upon redemption.
There is no guarantee that the Fund will meet its investment objectives.
Basis Point: A unit for measuring a bond yield that is equal to 1/100th of a 1% yield. A 1% change = 100 basis points (bps)
Before investing, carefully consider the Fund’s investment goals, risks, charges, and expenses. For a prospectus containing this and other information, contact your financial advisor or visit our literature library. Read it carefully before investing.