It s generally assumed that municipal bonds are exempt from federal taxes, but it s important for investors to know all of the nuances of these securities. Certain municipal bonds are subject to the Alternative Minimum Tax (AMT), so it s essential to understand which types of bonds are subject to it, and how to avoid such securities if you so desire.

Intro to AMT

Alternative minimum tax, or AMT for short, is an additional tax that is paid on top of income tax. The name is derived from an alternative set of rules used to determine a minimum amount of tax that individuals must pay. Originally passed into law to prevent high income individuals from avoiding tax altogether, AMT now affects millions of people due to bracket creep, where inflation pushes income into higher tax brackets. Part of the reason for this is because AMT rates and exemptions have not been indexed for inflation or income growth, but taxpayers income continues to rise.

With income tax, various tax deductions can be used to reduce your taxable income; with the AMT, however, many of these tax write-offs are not counted, thereby increasing a person s taxable income. Each year a taxpayer must pay the greater of the AMT or regular tax. Depending on whether it is public purpose or private purpose, municipal bond income may also be subject to the AMT.

Private Vs. Public Purpose Bonds

Most bonds used for projects, such as housing and student loans, are classified as private purpose. Public purpose municipal bonds, on the other hand, are used by municipalities for the public at large, not for private individuals; uses include roads, libraries and other infrastructure. The private versus public distinction is important to those who may be subjected to the AMT. Even facing a 28% tax rate once is enough for an investor to really consider whether they want to be involved with these investments.

Determining The Tax

To determine the amount of a fund s distribution be sure to check the tax information brochure, the company s website or the confirmation that is sent, which includes all of the details about the bond. The front cover of the official statement will tell you if the bond is subject to the AMT. AMT municipal bonds have no appeal to a taxpayer who could pay as much as 28% on his or her municipal interest income. A few funds advertise themselves as nearly or completely non-AMT.

Investors, knowing that municipal bonds may be taxed, require a higher yield to compensate. And conversely, an investor seeking tax-exempt funds may accept a lower yield in order to avoid the AMT. Typically, AMT bonds pay about 15 to 20 basis points over comparable non-AMT bonds--hardly worth it when the tax hit can be 28%. In addition, municipal bonds usually have lower yields than comparable Treasury bonds, but the tax savings should compensate for the difference.

Municipal Bond Considerations

Originally enacted as the Tax Reform Act of 1969 and passed in 1970 into law, the AMT has undergone several changes since then, with public purpose bonds coming into effect in 1986. Under the Tax Reform Act of 1986, as stated before, interest received on private purpose municipal bonds is classified as being subject to the AMT.

In addition to being subject to the AMT, municipal bonds can head south during bear markets just like any other asset class. With interest rates set to rise, it is another caveat for investors to consider, as bond prices and interest rates tend to move in opposite directions. That said, with the potential for a tax-free return, municipal bonds offer a solid return for those investors seeking yield.

Another investment to consider is municipal bond ETFs; they offer greater diversification and liquidity to easily move and out of any position. Investors should still be cautious, however, as some ETFs hold sizable positions in private purpose bonds, subject to the AMT.

The Bottom Line

If you are interested in investing in municipal bonds, do your due diligence and see if it is subject to the AMT. The decision made after weighing the benefits and drawbacks depends on each investor s needs and individual circumstances. If in doubt, contact your nearest tax accountant.