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Fixed-Income Insights

Steady inflows into AMT-free municipal bond mutual funds are a reflection of the increasing reach of the tax into middle-class wallets.

 

In Brief

  • The alternative minimum tax (AMT) continues to be a source of frustration for taxpayers and their financial advisors, and it is one reason why inflows into AMT-free municipal bond funds increase each year around tax season.
  • The tax’s scope has grown exponentially since 1979, hitting more and more middle-class taxpayers, and moving beyond its original intent to achieve fair and equitable tax reform.
  • The law is so complex that many taxpayers first learn they are liable only after preparing their tax returns, when it is too late to increase withholdings or make estimated tax payments.
  • Key takeaway: The ultimate solution will require serious tax reform. Until that time, investors may find some refuge in actively managed AMT-free municipal bond portfolios. 

 

If you’re a middle-class homeowner living in a high-tax state, the chances are very good that you’ve been hit with the alternative minimum tax (AMT). If you are married, have a large family (i.e., claim more dependents), and own a home in a high-tax state, you’ve hit the trifecta, at least in terms of the impact of the AMT on your wallet. 

One of the myths surrounding the AMT is that only the very wealthy need be concerned. But more and more middle-class taxpayers each year are hit with an unpleasant surprise at tax season. While it is true that the AMT primarily affects well-off households, it does not affect those with the very highest incomes.  According to the Urban-Brookings Tax Policy Center (TPC), in 2015, 27% of households with expanded cash income (a broad measure of income) of $200,000–500,000 were affected by the tax, as were 59.1% of those with incomes between $500,000 and $1 million—but only 19.7% of households with incomes greater than $1 million were affected.

Calculating the AMT is like living in an alternative universe. Every year at tax season, millions of taxpayers are required to calculate two sets of income taxes: one for regular income tax purposes and one for AMT purposes. The AMT essentially disallows many of the deductions and exemptions taxpayers take advantage of to reduce their regular income tax liability, such as those for state income and property taxes, dependents, and most miscellaneous itemized deductions, such as business expenses. After the two calculations are made (one for the regular system of taxation and one for AMT), the taxpayer is expected to pay the greater of the two. (The difference between the two is the AMT.)

The law is so complex that the Internal Revenue Service’s wage withholding calculator does not even consider the AMT in determining how much taxpayers should withhold. So, many taxpayers first learn that they are subject to the AMT only after preparing their returns, when it is too late to increase their withholding or make estimated tax payments, and that makes them liable for penalties. Some taxpayers can’t afford to pay their tax (or penalties) in one lump sum at the end of the year.

This is a huge source of frustration not only for investors but also for their financial advisors, who, after all, want to see their clients earn the maximum aftertax return possible, given, presumably, their clients’ tolerance for risk. And it is one reason why inflows into AMT-free municipal bond funds increase each year around tax season.

This article cannot provide tax advice, which investors would be wise to seek from qualified professionals. What it does seek to do is educate investors about the AMT itself and how he or she can lessen the AMT’s impact on their investment returns.

Origins in a Political Firestorm
But, first, a little history about the AMT and what it was intended to do. The AMT had its genesis in 1969, when then-Treasury Secretary Joseph W. Barr disclosed to Congress that 155 wealthy individuals had paid no federal income tax in 1966 (largely through legally allowed special deductions, special credits for expenses, and preferential treatment of some income). The news set off a political firestorm on Capitol Hill, as constituents demanded an investigation and a remedy into the perceived inequity. Later that year, Congress enacted legislation that created a minimum tax to prevent wealthy individuals from taking undue advantage of laws to reduce or eliminate their federal income tax liability. As originally conceived, the minimum tax was an “add-on” tax that wealthy households paid in addition to any regular income tax they owed. In 1970, the new tax affected 19,000 taxpayers and generated $122 million for the U.S. government, according to the Urban-Brookings Tax Policy Center.

The tax’s scope has grown exponentially since. Its modern-day version, the AMT, was introduced into the tax code in 1979. But unlike the regular income tax system, Congress did not index the AMT for inflation. Thus, over time, as a taxpayer’s income rose with inflation, AMT liability rose relative to regular income tax liability. Since taxpayers paid the larger of the two taxes, inflation pushed more people on to the AMT, and the government’s AMT revenue (both in absolute terms and as a share of regular individual income tax revenue) increased steadily over time.

Congress repeatedly passed legislation—known as the AMT “patch”—to prevent an explosion in the number of AMT payers. Each patch boosted the amount of income exempt from the tax, saving millions of households from having to pay the levy. The 2011 patch, for example, left just 4.3 million taxpayers owing AMT, according to the TPC, down from 29 million who otherwise would have paid the additional tax. But Congress refused to approve a permanent fix because it deemed the potential revenue loss too high.

A break for taxpayers came in 2012 when Congress passed the American Taxpayer Relief Act [ATRA] of 2012, which set a higher and permanent income exemption and indexed that and other AMT parameters for inflation. According to TPC, as a result of ATRA, the number of AMT taxpayers fell, from 4.6 million in 2012 to about 4.1 million in 2015 (down from an expected 41.8 million taxpayers who otherwise would have faced the AMT in 2015). TPC expects that number to grow modestly, to 4.8 million by 2025. Post- ATRA, AMT revenue is projected to increase, from $28 billion in 2015 to $44 billion in 2025. Without the ATRA fix, TPC estimates the tax would have generated $178 billion in 2015, increasing to $428 billion by 2025.

ATRA prevented an explosion in the number of tax filers ensnared by the AMT, and it eliminated the need for Congress to revisit the issue every year or so, but it’s not a truly permanent fix. The AMT will still hit three or four million often unsuspecting taxpayers each year and is likely to hit more people over time (see Chart 1), because indexing AMT parameters doesn’t protect taxpayers as their real income grows.

 

Chart 1: The Number of Taxpayers Affected by AMT Is on a Growth Path, Despite ATRA
1970–2025E

Sources: Urban-Brookings Tax Policy Center and the Internal Revenue Service.
Notes: Figures include those who paid the original add-on minimum tax that Congress repealed in 1983.  Taxpayers affected by the AMT include those with direct AMT liability on IRS Form 6251 as well as those with lost credits and/or reduced deductions.

 

Because the AMT, even post-ATRA, still disallows the state and local tax deduction and dependent exemptions, families with children who live in high-tax states are among the most likely to owe AMT.  According to the TPC, allowing those deductions and exemptions would have reduced the number of taxpayers affected by the AMT in 2015 to just 500,000 instead of 4.1 million.

Public versus Private-Activity Municipal Bonds
With every election, there can be found one or more candidates who pledge to repeal the AMT altogether.  This year’s presidential campaign is no exception. But making investment decisions based on the political winds of the day is probably not a sound idea. The AMT, after all, has been embedded in the U.S. tax code for nearly 40 years (since 1979), and a variant of it was part of tax policy for nearly a decade earlier.  It is, then, likely to be with us for a while yet.

Rather than pinning hopes on election results to repeal the tax, a more prudent step might be to put assets into an investment vehicle that invests exclusively in municipal bonds exempt from the AMT.

The interest earned from most municipal bonds is exempt from federal income taxes—a unique feature that sets them apart from all other capital market securities. Municipal bonds often are issued to finance a project that will be used by the public at large, such as libraries, roads, and other infrastructure purposes. But municipal bonds also are issued for purposes that are outside the realm of specifically government functions. Such bonds include private-activity issuers, such as airports and certain types of housing agencies. Unlike public-purpose bonds, private-activity bonds must be included in the calculation of AMT income for federal tax purposes.

(There are exceptions, however. Private-activity bonds may be exempt from AMT if they fall within the category of “qualified bonds,” as defined in the U.S. Tax Code. For example, bonds issued to finance the construction of a solid waste facility might be considered exempt from the AMT even though the facility will be owned by a private waste management company.)

Given that private-activity municipal bonds (AMT bonds) may be taxable, why would anyone buy them versus AMT-free bonds? Generally, the yield on a private-activity bond will be higher than the yield on a public-purpose bond, reflecting the risk that it could become taxable for the investor at some point in time, as the investor increases his or her income in the future and becomes subject to the AMT. Until that time, however, the AMT bond represents a significant opportunity to enhance yields. According to Bloomberg, the current spread differential between AMT and AMT-free revenue bonds is between 30 basis points and 48. With yields on investment-grade long bonds currently around 2.5–3.0%, this can represent more than a 10% increase in yields.

Conclusion
Steady inflows into AMT-free municipal bond mutual funds in recent years are a reflection of the increasing reach of the AMT into middle-class wallets. Certainly, they mirror inflows into the separately managed accounts of high-net-worth taxpayers; most such accounts have a long history of avoiding bonds subject to the AMT. Even municipal bond funds not touted as “AMT-free” typically have only 10% of their portfolios invested in bonds subject to the tax, because more and more investors are subject to it. Still, if someone ends up just being on the threshold of needing to pay AMT, this small amount of their income could be the factor that causes them to pay higher taxes.

Nonetheless, most taxpayers find themselves hit by the AMT not because they engage in egregious tax sheltering but because they are married, have large families, or live in high-tax states. So, it can rightfully be said that the original intent to develop a sound and equitable tax policy has missed its mark and created unintended consequences.

The ultimate solution will require serious tax reform. Until that time, investors may find some refuge in actively managed AMT-free municipal bond funds or separate accounts, where the complexity of the tax code can be managed for the purpose of maximizing aftertax returns. For an increasing number of investors, it’s not the return but what you get to keep of it that matters.

 

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