The expanding reach of the alternative minimum tax has the media buzzing and taxpayers troubled. As a result of the AMT's growing reach and uncertainty created by stopgap legislation over who will owe, taxpayers are exploring all available options in the tax code to reduce or eliminate their AMT liability. That exploration puts AMT-free municipal bond funds in the spotlight. Is this a good investment option for taxpayers? And is it even a good tax strategy?
Enacted in 1969 to limit tax sheltering by the ultra-wealthy, the AMT is on track to reach 23.4 million taxpayers in 2007--most for reasons that have nothing to do with tax sheltering. The practice by Congress in recent years has been to temporarily patch the AMT so that fewer people are hit: only 3.5 million paid AMT in 2006. This year Congress is considering both a patch and a permanent fix.
Meanwhile, for high-net-worth individuals, paying the AMT has become routine. And with inflation and growing incomes, more upper-middle-class taxpayers are falling into AMT territory. In 1970, some 20,000 taxpayers paid the AMT, but in its current form it is predicted to reach 39 million people--more than one-third of taxpayers--in 2017, according to the Urban-Brookings Tax Policy Center, a Washington-based tax-analysis think tank.
This has put a new focus on municipal bonds. While interest earned on municipal bonds is free from federal tax and state tax if issued by the taxpayer's home state, interest on private-purpose municipal bonds--issued to fund housing, student loans, airports and industrial type projects--is subject to the AMT. Therefore, investors subject to the AMT face taxes of either 26 percent (on the first $175,000 of income) or 28 percent (on all income over $175,000) on the interest income earned from private-purpose bonds.
As more taxpayers become subject to the AMT, it is only natural that high-net-worth investors and their advisors have begun paying more attention to private-purpose bond interest. Given the list of tax preference items that may be eliminated to reduce AMT liability, private-purpose bond interest jumps out as an easy fix since many of the other items are more difficult to control. Taxpayer awareness of the potential drawbacks of private-purpose bonds also has led to an effort by many mutual fund companies to offer funds that seek to avoid AMT as well as state and federal tax.
A number of special situations cause taxpayers to become subject to the AMT, but in general, they fall victim to it if they have high deductions relative to their incomes. Some taxpayers fear the AMT so much, they may consider converting taxable investment income to AMT-free municipal bond income in an attempt to avoid the AMT. While this strategy may reduce their overall tax liability, it might have little effect on their AMT status since they are likely caught in the AMT system due to high deductions.
Reducing tax--whether AMT or regular tax--is a worthwhile pursuit, but structuring an investment program around the avoidance of the AMT may be a futile effort. However, if a taxpayer has determined that his circumstances will likely lead to payment of the AMT, and he is currently invested in municipal bonds, then he can easily reduce but not eliminate some of his tax liability by avoiding private-purpose municipal bonds. Just as taxpayers consider the choice between taxable corporate bonds and municipal bonds by evaluating the after-tax return, they must make a similar choice between municipal bonds that are subject to AMT and those that are not by evaluating the after-AMT return.
Advisors must also determine if AMT-free funds make sense for clients from an investment perspective. As you might expect, in order to attract investors, private-purpose bonds have traditionally paid a higher interest rate than other municipal bonds. The spread between private-activity bonds and other municipal bonds is roughly 20 basis points, ranging historically from 10 to 30 basis points, according to Josh Gonze, co-portfolio manager of municipal bond funds at Thornburg Investment Management.
The spread is crucial to advisors evaluating tax-free investment options for clients. There are Web sites that assist investors in determining the after-tax yield for municipal bonds, but not many resources exist for investors seeking to determine the after-AMT yield and the attraction of an AMT-free municipal bond may hinge on the after-AMT yield. As yield spreads between AMT-free and private-purpose bonds narrow, private-purpose bonds become less attractive since their after-AMT yield is reduced relative to AMT-free bonds.
Advisors must be able to determine the after-AMT yield for a private-purpose bond. The evaluation is relatively straightforward. The two tax rates for taxpayers subject to AMT are 26 percent and 28 percent. If an investor is trying to determine the attractiveness of a private-purpose bond, he must first determine his AMT tax rate. Assuming that an investor is subject to AMT, and his tax rate is 26 percent, then the after-AMT yield would be the current yield times 1 minus the tax rate of 26 percent. Conversely an investor can determine an AMT equivalent yield for an AMT-free bond by dividing its yield by 1 minus the tax rate of 26 percent.
Private-Purpose Bond--Yield 7%
After AMT yield is:
7%*(1- 0.26%) = 5.18%
AMT-Free Bond--Yield 5%
AMT equivalent yield is:
5%/(1 - 0.26%) = 6.76%
In this example, we can see that at a yield of 7 percent, the bond must be priced to yield 1.82 percent higher than a bond that is AMT-free. Of course the nominal yield differential needed to compensate an investor subject to AMT varies with the level of interest rates. Advisors simply need to know that for an investor in the 26 percent AMT bracket, the yield of a private-purpose bond must be 35 percent higher.
While evaluating the attractiveness of individual bonds is relatively straightforward, the evaluation of bond funds investing in AMT-free versus private-purpose bonds is more complex. And although history is not predictive of the future, it may be useful to evaluate the recent performance of bond funds that invest in AMT-taxable bonds versus AMT-free bonds. The table on the next page, derived from data provided by Lipper Analytics, illustrates the historical returns of municipal bond funds.
The analysis shows the total returns of funds that currently hold bonds subject to AMT and funds that are AMT-free. The percentage of the portfolio subject to AMT varies from fund to fund and may vary across time. As previously noted, the excess yield required for an investor to be compensated for AMT is 35 percent. The analysis shows that on average, the difference in excess return has been minimal, and that the return differential may not be high enough to compensate taxpayers subject to AMT--even at the 26 percent rate.
Obviously the simple analysis does not consider the amount of the total return derived from private-purpose bonds, which may impact the analysis, but it does illustrate that investors should be cautious when pursuing funds with AMT exposure in search of higher returns. Advisors may also conclude that the return differential in the two types of funds is not meaningful, and therefore it may be prudent to simply avoid unwanted exposure to funds holding bonds subject to AMT.
"I view the spread in yield as a fairly small reward for taking on the AMT," Thornburg's Gonze says.
Reflecting that view, Thornburg was among the first fund companies to offer AMT-free funds. Its Limited Term Municipal Fund has been AMT-free for more than 10 years. Its New York Intermediate Municipal Fund is an AMT-free fund that's designed to cater to demand from New York, which, as a high tax state leads to more AMT taxpayers.
With the potential to hit 23.4 million taxpayers in an election year, Congress is expected to act in some way to limit the AMT's bite. Outright repeal of the AMT is not likely, however. Leonard E. Burman, director of the Tax Policy Center, testified in late June before the U.S. Senate Committee on Finance that "outright repeal of the AMT, without any other offsetting changes, would reduce tax revenues by more than $800 billion through fiscal year 2017, assuming that the 2001-2006 tax cuts expire after 2010. If the tax cuts are extended, the 11-year revenue loss nearly doubles to almost $1.6 trillion."
"Congress will not eliminate the AMT because they are too accustomed to the revenue," Gonze says. "And my suspicion is that we will see more AMT-free funds since Congress will not eliminate the AMT."
As Congress and tax analysts wrestle with what to do with the AMT, taxpayers are left to plan for what they can. Based on historically tight spreads between AMT-free bonds and private-purpose bonds and the return differential of municipal bond funds with holdings subject to AMT and those that are AMT-free, there is little motivation for advisors to recommend bond funds that may increase a taxpayer's AMT liability.
If an advisor has determined that municipal bond funds should be a portion of an investor's portfolio, it would be wise to select a fund that has little or no exposure to private-purpose bonds since the reward is minimal, but the risk of increasing an investor's AMT liability could be damaging to his after-tax return.
Finally, if Congress does not act to repeal or significantly overhaul the AMT, and the increasing number of investors subject to the AMT realize that they are not adequately rewarded for holding private-purpose bonds, prices may decline as investors force the spread in yield to widen to compensate for the additional tax liability.
For now, prudent advisors will look closely at AMT-free funds as another tool to assist in delivering the wealth management experience that clients expect.
Jerry D. Sais, CPA, CFA, AIFA, is an RIA and chief investment officer of REDW Stanley Financial Advisors, LLC in Albuquerque, N.M. Melissa W. Sais is an Albuquerque-based writer and editor.