Municipal bonds and muni funds generally are referred to as “tax-exempt” or “tax-free.” In many cases, though, that’s not the case.
For some municipal bonds, interest is exempt from regular income tax but subject to the alternative minimum tax (AMT). Thus, if you have to pay the AMT and you own such bonds, the interest becomes taxable.
The greatest pitfall, for many people, is an “adjustment” for state and local income and property taxes. If they’re substantial, in relation to your income, these items alone can throw you into the AMT. As your income (and the value of your home) increases and you pay more in state and local tax, you’ll increase the risk of owing the AMT. Here’s what you should do:
Check with your tax preparer to see if you’ll be subject to the AMT for 2002; if not, is such exposure likely in the next few years?
If you think you’ll soon have an AMT exposure, evaluate your municipal bond holdings. The disclosure documents will state whether or not a particular issue generates interest subject to the AMT. Sell your AMT debt and buy AMT-free issues.
Check your mutual fund holdings, too. Many funds load up on AMT issues to boost yields while others are prohibited from doing so. If a fund has 20 percent of its assets in AMT debt, for example, 20 percent of its income distributions will be subject to the AMT. Again, buy a less-taxing muni fund.
