Having some idea that municipal bonds are generally exempt from federal taxation, investors often mistakenly surmise that municipal bond funds and tax-exempt bond funds are one in the same. They’re not, and for investors who may be subject to the Alternative Minimum Tax, failing to distinguish between the two could be a costly mistake.
A little background: Because municipal bonds are generally issued to finance projects that will further the public good (such as roads, schools and libraries), it is also in the public interest for municipalities to be able to borrow the money to finance these projects at comparatively low rates of interest. To induce investors to purchase these relatively low-yielding instruments, municipal bond interest is generally exempt from federal taxation. However, if a municipality issues bonds that are tainted by some unqualified private purpose, the interest on these bonds is subject to the Alternative Minimum Tax.
Here’s what you need to know: While many mutual funds avoid private purpose bonds altogether, so-called "municipal bond" funds are permitted to invest 100% of their assets in private purpose bonds whereas "tax-exempt" funds are limited to 20%.
Bottom line: If you may be subject to the Alternative Minimum Tax, you’ll probably want to favor public purpose (or regular) municipal bonds over private purpose municipal bonds and tax-exempt bond funds over municipal bond funds. How best to determine whether a particular fund owns any private purpose bonds? It is usually easiest to call the fund directly.
