No one likes paying taxes, but clients get extra steamed when they are blindsided by a particularly hefty IRS bill.

Unfortunately, such tax surprises could become increasingly common for shareholders of municipal bond funds. The source of the problem is a much-hated creature known as the Alternative Minimum Tax (AMT) — a beast whose reach is growing. Concerned about the problem, a few companies are beginning to offer funds that sidestep the AMT.

The AMT began in the 1960s when outraged Congressmen discovered that a few wealthy people paid no taxes. To ensure that everyone sent something to Washington, the alternative tax system was devised. Under the rules, the fat cats saw their deductions reduced, and they paid taxes on income that had been sheltered. For years, few taxpayers were affected. But, because the system has not been adjusted for inflation, the AMT has been trapping more taxpayers. In 2002, three million taxpayers got socked. The figure could climb to 21 million in 2006 and 36 million in 2010, says the Urban-Brookings Tax Policy Center in Washington. In the next decade, the tax should hit most people with incomes over $50,000.

The Great Divide

In the strange world of the AMT, income from many municipal bonds is taxable. The bonds are divided into two categories, public and private. Public bonds — which finance government activities, such as sewer projects — are never taxed under the AMT, but private-activity bonds can be. The private bonds are issued when a municipality authorizes a company to sell tax-free bonds. For example, many power companies have sold bonds to pay for pollution-control systems. The private bonds are backed by the corporate issuers. Other private-activity bonds are backed by revenue from stadiums and airlines.

To compensate for the tax risk, private-activity bonds often yield 20 to 50 basis points more than comparable public bonds. Because of the extra yield, AMT bonds have long been favorites of fund portfolio managers.

Many funds have more than 20 percent of their assets in AMT issues, and some high-yield municipal funds have more than 50 percent in the bonds. For investors trapped by the AMT, the private-activity income could be taxed, while the public bonds would always remain tax-free. AMT investors face taxes on private-activity income at rates of up to 28 percent. That can be a steep tab — particularly for an investor who thought he owned a tax-free bond fund.

To find out the percentage of income that comes from private-activity bonds, you can call the fund's toll-free line. Some companies, including Fidelity Investments and Thornburg Investment Management, now post the AMT percentages on their Web sites. The names of funds can also provide clues about AMT holdings. Under SEC rules, a fund can't have “tax-free” in its name unless the portfolio gets less than 25 percent of its income from AMT bonds. Funds that have “municipal” in their names can have as many AMT bonds as they want. To highlight their intentions, a few funds have recently changed their names, including Scudder Tax/AMT Free.

Advice and Good Sense

Because few investors have faced the AMT in the past, many advisors have ignored the issue. But that seems likely to change, and advisors must now decide whether to buy funds with private bonds.

“If two funds are equally strong, I will chose the one that avoids AMT bonds,” says Carl Stuart, an independent registered investment advisor in Austin, Texas, who clears trades through Raymond James Financial Services.

For conservative clients, Stuart prefers Thornburg Limited Term Municipal, a fund that holds mostly AAA-rated bonds and steers away from AMT issues. Thornburg avoids placing big bets on interest rates. Instead, it holds a laddered portfolio that includes bonds with maturities of one year, two years, three years and so on. By staying broadly diversified, the portfolio provides relatively steady results in good and bad markets.

To reach investors concerned about the AMT, some companies have begun shifting their portfolios. Late in 2002, Oppenheimer eliminated AMT bonds from a fund and renamed it Oppenheimer AMT-Free Municipals. The company also introduced Oppenheimer AMT-Free New York Municipals because many high-income investors in that state face the AMT.

AMT-Dodging Funds
Fund Ticker One-year Return Three-year Return Five-year Return Maximum Front Load
Eaton Vance Municipal Bond A ETMBX 7.7% 5.7% 6.0% 4.75%
Oppenheimer AMT-Free A OPTAX 9.7 5.5 4.7 4.75
Oppenheimer AMT-Free NY A OPNYX 8.2 4.2 5.0 4.75
Scudder Intermediate Tax/AMT Free A SZMAX 4.3 4.1 4.6 2.75
Thornburg Limited-Term Muni LTMIX 3.2 4.2 4.9 0
Source: Morningstar. Returns through 7/31/04.

Oppenheimer portfolio manager Ronald Fielding, a New York resident, ranks as the largest shareholder in the New York fund. “When I learned in 2003 that I would be subject to the AMT, I moved my money to the New York fund,” he says.

For the moment, most clients do not face the AMT, so they can consider holding private-activity bonds. Because they are backed by corporations, many private-activity bonds are less secure than bonds supported by the full taxing power of a state. Still, AMT bonds post minimal default rates. The bonds come in a variety of credit qualities, ranging from junk to AAA, the top grade awarded by Standard & Poor's.

Some fund companies now offer several funds with different amounts of AMT holdings. Eaton Vance Municipal Bond A has no AMT bonds, while Eaton Vance High-Yield Municipal A has 29.6 percent of its assets in AMT issues. Aggressive clients with no AMT exposure may prefer the high-yield fund, which has an SEC yield of 6.54 percent, compared to a yield of 5.20 percent for its sister fund. Both funds finished in the top quarter of their categories in the past five years.

“We present different options and let the broker decide which AMT percentage is best for each client,” says Thomas Metzold, an Eaton Vance portfolio manager.

Of course, the whole AMT concern could go away if Congress decides to eliminate the mess of tax laws. But don't bet on that happening. Washington needs extra money, and the AMT provides a hidden way to soak people without appearing to raise taxes. Unless Congress suddenly changes its ways, more clients will soon be craving ways to dodge the AMT and insure that their municipal funds really are tax-free.