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What is the alternative minimum tax?
The AMT is a tax computed under different rules than the regular federal income tax. Taxpayers are subject to the AMT if their tax liability under the AMT is greater than their tax liability under the regular federal income tax.
The AMT was originally created to impose a minimum amount of tax on high-income taxpayers who qualified for significant tax savings. Through the use of certain tax deductions and exemptions, some high-income taxpayers significantly reduced or eliminated their regular federal income tax liabilities.
Why are more people affected by the AMT?
The AMT thresholds have not been adjusted for inflation, so more taxpayers become subject to the AMT as income levels rise. Temporary AMT patches have been signed into law in recent years, including for 2009, that adjusted exemption amounts to certain fixed, higher dollar levels. It remains to be seen what will happen in 2010. Without any changes, it is estimated that by 2010, the AMT will affect 29.9 million taxpayers—about a third of all tax returns—up from 1.6 million in 2000.1
In contrast, regular income tax rules adjust tax brackets and personal exemptions for inflation on a yearly basis. Under the regular federal income tax structure, the tax liability increases when incomes rise faster than these adjustments for inflation.
How is the AMT calculated?
The AMT is generally calculated by adding back certain deductions and certain exemptions to your adjusted gross income to determine your alternative minimum taxable income.
Unlike the regular income tax, the AMT does not generally allow deductions for personal exemptions and state and local income taxes, to name just a few of the differences. For more information, please consult your tax professional.
How does the AMT affect muni bond investors?
Income from certain types of municipal bonds, such as private activity bonds, is sometimes included when calculating alternative minimum taxable income. So municipal bond investors who are subject to the AMT need to be aware of what types of bonds they're purchasing and their potential tax implications.
Private activity bonds are issued primarily to finance quasi-public projects, such as building stadiums and airports. Private activity bonds have typically offered higher interest income than other types of municipal bonds to compensate bondholders for not being fully tax exempt. While the interest earned from private activity bonds has been exempt from regular federal income taxes, it has been considered taxable income under the AMT. Because of this, private activity bonds have been called "AMT bonds." Taxpayers have won a temporary reprieve. Under the American Recovery and Reinvestment Act of 2009, the interest earned from private activity bonds issued in 2009 and 2010 will not be subject to the AMT.
Do Franklin funds invest in "AMT bonds"?
While Franklin does not have funds that are restricted from investing in AMT bonds, our managers are sensitive to the growing impact the AMT can have on shareholders' tax-free income. As a result, Franklin managers generally limit portfolio exposure to AMT bonds.2
Keep in mind, AMT liability is based solely upon your personal financial circumstances. Owning a mutual fund that invests in AMT bonds will not necessarily trigger AMT liability.
How can I minimize my AMT liability?
To minimize your AMT liability, look for municipal bond funds with "tax-free" or "tax-exempt" in their name. These funds can invest no more than 20% of their assets in bonds with income subject to the AMT, in accordance with the U.S. Securities and Exchange Commission (SEC) rules under the Investment Company Act of 1940.3
We encourage you to work with your financial advisor and tax professional to determine which funds may make sense for you.
What are the risks?
Municipal bonds are affected by interest rate movements. Municipal bond prices, and likewise a municipal bond fund's share price, generally move in the opposite direction of interest rates. As the prices of bonds in a fund adjust to a rise in interest rates, the fund's share price may decline. These and other risks are detailed in a fund's prospectus.
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