January 12, 2006
Coping with the Alternative Minimum Tax
With millions getting hit by the AMT, a number of funds are specifically geared to avoid the pain. Here are some to consider
An estimated 3.8 million taxpayers this year -- and 20.5 million in 2007 -- will be slapped with the AMT, according to the Treasury Dept. They'll face a heftier bill from Uncle Sam, and extra paperwork, too.
Efforts are afoot to repeal the unpopular levy. The House of Representatives and the Senate are hashing out legislation that would spare taxpayers from the AMT. In late 2005, the President's Advisory Panel on Federal Tax Reform recommended changes that would include the AMT's demise. But it's unclear whether lawmakers will find room in the budget to slash another revenue source.
WHO BENEFITS MOST. So with the AMT still alive and kicking, mutual funds are increasingly targeting investors who dread the tax. Typical tax-free bond funds aren't really tax-free when it comes to the AMT. But funds such as the Fidelity AMT Tax-Free Money Fund (FIMXX ) or the Putnam AMT-Free Insured Municipal Fund (PPNAX ) invest only in securities that aren't subject to the tax.
"This is an area where people can look for current income, especially when they're in the upper tax brackets," says Tom Roseen, a senior analyst with New York-based fund tracker Lipper.
AMT-free funds are ideal for investors who already know they have a need for municipal securities, according to Eric Jacobson, a senior fund analyst with Chicago-based fund tracker Morningstar. Folks typically pour their money into munis because their tax efficiency can mean higher returns, depending on individual circumstances. Investors can use a number of online tools to determine whether municipals are right for them. Then, they should check with tax planners about their AMT risk. "If you think you might be subject to AMT and you want a muni fund, it's fine to err on the side of caution and buy the AMT-free fund," Jacobson says.
NOT EASY TO TRACK. Not all AMT-free funds are alike. They can come from any category of municipal money-market or bond fund, including short, intermediate, and high-yield. "It's good because it gives investors choice, but it makes it more difficult to track the funds," says Brian Boswell, a research analyst for Financial Research, a Boston-based firm. On the plus side, he says the funds' performance is competitive with their AMT-bearing peers.
Fidelity Investments recently introduced its eighth AMT-free fund, the most of any fund company. In 2004, the Boston-based fund complex changed the goals of its five municipal money-market funds to include avoiding the contentious tax. In 2005, Fidelity updated the funds' names to reflect their new AMT-free strategy and lowered the investment minimums on them from $100,000 to $25,000. Expense ratios range between 0.33% and 0.40%, relatively low for muni funds.
Fidelity also offers an AMT-free bond fund, Fidelity Tax-Free Bond Fund (FTABX). It has posted returns that beat its peer-group average each full year since its inception in 2001 and charges a 0.25% expense ratio that's well below average.
DIGGING DEEP. At American Funds, the Tax-Exempt Bond Fund of America (AFTEX) has been AMT-free since it was introduced in 1979. The fund charges a 3.75% initial sales load and carries a relatively low 0.57% expense ratio. It has beaten its category average over a three- and five-year period, according to Morningstar.
Dexter Williams, manager of the Los Angeles-based fund company's fixed-income department, attributes the fund's record to superior research capabilities. "Most people don't think of research on the municipal side, but we find it to be very important," he says.
Launched in 1978, Eaton Vance Municipal Bond Fund (ETMBX) is another long-running AMT-free fund. The portfolio has a 4.75% sales load and has a slightly below-average expense ratio of 0.91%. Meanwhile, its performance has handily beaten its benchmark Lehman Brothers municipal bond index every year since 2000.
TAKE THE LONG VIEW. "For the right individual, a non-AMT fund is an absolutely fabulous idea," says Tom Metzold, portfolio manager for Eaton Vance National Municipals (EANAX ). "But one has to do the calculations to determine whether they would better off with a fund that does have some AMT exposure."
Oppenheimer Funds offers a pair of AMT-free funds that seek higher yield than their competitors, but may entail more risk by investing up to 25% of assets in junk bonds. Oppenheimer AMT-Free Municipals (OPTAX ) has expenses of 0.92% and the Oppenheimer AMT-Free New York Municipal (OPNYX ) expenses of 0.93%, while both charge a 4.75% front-end sales load. Over a five-year period, the national fund ranks in the top 2%, and the New York fund in the top 4% of their respective Lipper peer groups.
"People should consider them as long-term holdings," says the funds' manager, Ron Fielding, a senior vice-president with the New York-based company. "When you get out and look at a bond fund's performance over 10 years, most of its total return will come from its yield."
AMONG THE UNLABELED. Some funds may try to avoid the pesky tax even if they're not specifically AMT-free. Take the $3.9 million Dreyfus Tax Managed Balanced Fund (DLMBX ), launched last fall. The fund combines Dreyfus' municipal-bond management with stock picks from institutional equity manager Fayez Sarofim & Co. It has expenses of 1.15%.
"While [the fund's] prospectus [says] we can buy bonds subject to the AMT, we endeavor that we will not do that," says Paul Disdier, director of municipal securities with the New York-based group. Dreyfus hasn't put AMT-free language in the fund prospectus, he says, for fear of boxing itself in should the tax be overturned by Congress.
Similarly, Putnam Investments shies away from AMT-laden securities across its entire tax-exempt lineup. The Boston-based fund company also offers Putnam AMT-Free Insured Municipal Fund (PPNAX ), which avoids the tax completely. This fund has a 0.84% expense ratio and a front-end sales load of 3.75%, though its performance has trailed its category average for the past three years, according to Morningstar.
AN AMT-FREE FUTURE? Even investors who aren't currently hit with the AMT should take a long-term approach to the issue, because next year they might be, according to David Hamlin, team leader of Putnam's tax-exempt fixed-income team. That's particularly true for investors in high-tax states or those who have dual incomes. "If you've chosen a fund purely on yield and not lifted the hood and dug around in the engine, you might be buying yield that's coming a lot from the AMT," Hamlin says.
The AMT-wary can only watch and wait as legislative efforts to kill the tax grind along. But in the meantime, some investors might find these fund alternatives a little less taxing. As Morningstar's Jacobson says, "I don't think anyone is likely to be hurt by buying an AMT-free fund, even if the AMT ceases to become a worry."