Some holders of municipal-bond funds will be in for a surprise next tax season when it turns out that their tax-free investments are subject to tax after all. But others won’t get stung because they have chosen the right municipal funds — those geared to avoiding the alternative minimum tax.
The AMT is a separate system that excludes several common deductions. It was intended to force wealthy Americans to pay their fair share of federal taxes. But over time it has come to snare more middle-income taxpayers. One of the biggest AMT surprises awaits investors who use tax-free municipal bond funds and municipal money-market funds to generate income. Under the AMT, some of that income might not really be tax-free at all.
Investors can also run into trouble when their funds buy so-called private-activity bonds, issued on behalf of a corporation for public projects such as airport terminals, hospitals or certain types of industrial parks. Unlike traditional municipal bonds, the interest income on private-activity bonds is taxable under the AMT, although not under the regular income tax.
Avoiding the AMT
Finding which funds hold those bonds can be challenging. One clue is in the name. Call a fund “tax-exempt” or “tax-free,” and under Securities and Exchange Commission rules it can invest up to 20% in AMT bonds. Call it a “municipal” fund and the percentage can go higher.
A fund’s prospectus will tell you if it invests in AMT-exposed bonds. And fact sheets on fund-company Web sites often show the percentage of AMT bonds held. If not, ask the fund company directly. Be careful of the fund you’re looking into, because different funds will have different mandates.
Several fund companies have devised a way to ease the AMT bite, offering funds that are completely free from AMT exposure. Some even label these funds “AMT-free” to make their objective perfectly clear.
Single-state funds typically buy issues only in one state so that residents of that state get both a federal and state exemption. States generally don’t tax bond income from issues of their own municipalities. Those funds are generally better choices for residents in hightax states such as New York, New Jersey, California and Massachusetts.
If AMT becomes an issue for you, fund companies’ Web sites can be good resources for information.
Managing AMT exposure is but one method of avoiding that tax. Besides advising that investors should do careful research on tax-free funds, we suggest spreading income deductions, tax payments and capital gains over time. For instance, if the AMT could hit you next year, pay estimated state income and local property taxes this year to claim the deduction.
Bottom line: It’s not about what you earn; it’s really about what you keep.
The information herein contained does not constitute tax or legal advice. Any decisions or actions based on information contained herein should not be made without first consulting a CPA or attorney.
For more information contact Compass Asset Management Group, LLC at 845.563.0537 or Contact@CompassAMG.com
The author of this blog, Steven M DiGregorio is President of Compass Asset Management Group, LLC and an Investment Advisor Representative with Spire Wealth Management, LLC a Federally Registered Investment Advisory Firm. Securities offered through an affiliated company Spire Securities, LLC a Registered Broker/Dealer and member FINRA/SIPC.