Did you get snagged last year by the beast behind the US Internal Revenue Code? Rather than stew over it, get to know the ABCs of how your bond investments can help you avoid the AMT trap.

By Benjamin Shepherd and Neil George

The right to levy taxes on its citizens is one of the cornerstones of government. Millions of Americans, voluntarily though begrudgingly, mail their tax payments to the Treasury every year. Most of us understand that without that money, our government wouldn’t be able to provide things like national defense, interstate highways and federal courts, the benefits of which most of us enjoy on a daily basis.

However, during congressional hearings in 1969, then-Treasury Secretary Joseph Barr revealed that 155 of the wealthiest Americans had paid little or no income tax in 1966 due to exemptions, tax shelters and other loopholes in the tax code. An outraged American public sent more mail to Congress in 1969 regarding those 155 tax dodgers than about the Vietnam War.

In response to the criticism, Congress passed the Tax Reform Act of 1969, which created the separate though parallel system of taxation we now know as the Alternative Minimum Tax (AMT).

Under the AMT, taxpayers have to complete the usual Form 1040 to calculate what they owe using all of the typical deductions, then calculate what they would owe under the AMT by completing Form 6251. Form 6251 disallows most exemptions and deductions and typically shows a much higher adjusted gross income (AGI). If the amount you owe based on Form 1040 is greater than that on Form 6251, you’re in the clear. However, if the amount on Form 6251 is greater, that is the amount you pay. Keep in mind that this is a quick and dirty explanation of how the process works, so for more information you should consult your tax advisor on your own specifics.

As with every action our government takes, the AMT has its supporters and detractors. The pro-AMT crowd says that it amounts to a flat-tax plan, which most equitably distributes the tax burden across the greatest number of Americans. Those against the AMT contend that it acts as a “head tax” and creates a situation of double taxation since it doesn’t allow you to deduct any state or local taxes you may pay.

While the AMT seemed like a great idea at the time, ensuring that every high-income American would have at least some tax liability, the plan had flaws that weren’t immediately apparent. The main issue is that the AMT isn’t indexed to inflation, as is the regular tax system. As incomes rise with the cost of living, more and more tax payers are caught in the AMT net. This creates a problem in areas such as Washington, DC and San Francisco, which have very high costs of living that are reflected in average salaries.

Bigger Catch

As an example, let’s consider a family with a household income of about $75,000. In the DC or San Francisco metro areas, that family would probably consider itself middle class, though it wouldn’t have much extra money. In a more rural area, they would probably be considered fairly well off with a good deal more disposable income.

However, because the AMT isn’t indexed to inflation or the cost of living, the urban family may find itself with a tax bill considerably higher than expected, placing an undue strain on finances if it didn’t have much saved. Unfortunately, an ever-growing number of Americans find themselves in this position.

According to a 2005 study conducted by the Urban-Brookings Tax Policy Center and the US Treasury Dept, about 3 percent of households making between $75,000 and $100,000 were subject to the AMT in 2000, but almost 15 percent of those households had to pay it in 2005. So, what do those of us who feel the pinch do about it?

For starters, we won’t wait for our elected officials to fix the problem. The Tax Policy Center estimates that it would actually be cheaper and easier to repeal the regular tax system than to eliminate the AMT as it makes the tax cuts implemented over the past few years much more affordable. In January, Senators Baucus and Grassley introduced legislation to repeal the AMT, which met stiff resistance after it was projected that the government could stand to lose more than $1.5 trillion over the next 11 years without the AMT, assuming the Bush tax cuts are renewed.

Despite the fact that the Congressional Budget Office projects that one in five tax payers will be subject to the AMT by 2010 and the IRS Tax Payer Advocate has identified it as the single most serious problem with the tax code, the government is going to be hesitant to part with that kind of cash.

Ditch The Hook

The key to reducing your exposure to the AMT is to reduce the amount of money you have to include when calculating your adjusted gross income on Form 6251. We’re not going to tell you to quit your job, stash your cash in the islands and live off the grid. We’re going to suggest that you buy municipal bonds.

You see, when you’re calculating your AGI, the income you derive from interest payments on certain types of municipal bonds doesn’t have to be included. They also have the added benefit of being exempt from state and local taxes, as long as they are issued by a political subdivision of the state in which you live. But if you’re thinking about trying this, it’s important to remember that not all municipal bonds are created equal, as the exemption states that the bonds have to be issued for a “public purpose.”

Municipal governments issue bonds to fund a variety projects such as public housing, economic development and building schools. But despite the fact that the bonds were issued under the authority of the government, that doesn’t automatically make the money for public purposes.

For instance, if the proceeds from the bond issue were used to build a public housing project that is later to be turned over to a property management company, the bond would be considered issued for private purpose. If the money were used to build schools that the local government would retain control of, this would be considered for public purpose.

How do you find out if a bond is for a public or a private purpose? The best place to start is the broker you purchase the bond through, as he or she should be able to tell you. Also, in most cases the information should appear on your confirmation page. If you know the CUSIP number for the bond, there are several web pages, including www.investinginbonds.com, which will allow you to look up them up.

Finally, there are closed-end municipal bond funds which are structured to minimize AMT liability. You’ll also find many closed-end muni funds that only hold issues from a particular state, so you can still enjoy the break from state and local taxes. These are an excellent option if you don’t have the enough cash on hand to make the minimum investment of $1,000 to $10,000 required for most individual issues.

Again, be sure to check with your broker or the fund manager to find out exactly how much of the income from the fund is AMT exempt, as some funds do sometimes include issues which are subject to the AMT to bump up overall returns.

Each individual’s tax situation will vary depending upon how much you make, where you live and what type of deductions you have, so you should always check with your tax advisor before making investment decisions. But if municipal bonds are something you haven’t looked at before, they’re definitely worth more research.

As always, keep checking back with us because we’re always on the lookout for great new issues.

Benchmarked

The following is free market commentary Neil George has written for his By George subscribers. The advice and recommendations below are simply for your benefit as investors. And recommendations listed below aren’t current Bond Desk recommendations, nor will they be followed and updated on a continuous basis. See above for the current Bond Desk recommendations and advice.

Much has been made about the recent new all-time high for the Dow Jones Industrials Average. Yes, the Dow Jones crossed 13,000, and based on all the excitement, you’d think that holding its components since 2000 had been a great strategy.

But only 13 of the 30 Dow members are up since January 2000, the last time the index had a lasting all-time high. In reality, there’s a better-than-even chance that if you held Dow stocks since 2000, you lost money. How is it possible to have an all-time high with only 13 stocks in positive territory since the last one?

It’s all about how the index is calculated. I asked my comrade, true technician and Personal Finance Associate Editor Ivan Martchev to go through the real issues with these benchmarks for the stock and other financial markets complete with all of their flaws. He provided me with the following:

The Dow Jones Industrials Average is a price-weighted index; the higher the price of the stock, the greater its weight. IBM, trading at approximately $100 a share, is the heaviest-weighted stock. Intel is the cheapest at just more than $21. A one-dollar move in IBM or Intel would produce the same effect on the Dow even though such a move would be much bigger on a percentage basis for Intel than for IBM.

The S&P 500, the most-important benchmark, is a different animal: It’s a market-cap weighted index. A one-dollar move for Intel is worth a lot more than a one-dollar move for IBM. Because the calculation is a bit more rational, most prefer the market-cap method of weighting an index.

But no system is perfect. The S&P 500 is dominated by the largest components, so in a way, as the top 50 stocks go, so goes the index. Investing in an index fund that tracks the S&P 500 is like investing in those 50 stocks, which never seem to make much progress.

An equal-weighted index sometimes tells a better story. If you recalculate the S&P 500 without weighting every stock by market cap, the picture changes completely.

Those same 50 stocks that pull down the S&P 500 and have prevented it from making a new high since 2000 have been put on even footing with every other stock in the index by a factor of 0.2. This equal-weight method can give you a better representation of what’s going on under the surface.

The massive outperformance of the equal-weighted S&P 500 over the market-cap weighted S&P 500 shows that small and mid-cap stocks have been the place to be in this bull market, rather than the usual suspects that dominated the market until 2000. The PF investment strategy has been to seek out those unusual opportunities.

Bonds can have even more varieties of indexes due to the different kinds, ratings and maturities involved; the combinations are numerous. The key thing to remember when looking at a bond index is to make sure you’re looking at the right one.

It’s often said that the Commodity Research Bureau (CRB) Index is the best representation of all commodities. The old CRB Index, which everyone used to look at, weighted all commodities equally, just like some stock indexes (e.g., the S&P 500 Equal Weight).

The index has 17 popular commodities–oil, copper, cotton and corn, among others–all carrying the same weight in the index. With this method, investors can better appreciate the breadth of the resource markets and won’t be misled by the movement in any single commodity.

When Reuters took over CRB, the title became Reuters-CRB Index, but the company also introduced the Reuters-Jeffries CRB Index, which is no longer equally weighted. The new index is marketed to institutional investors for use in futures index funds. The move was probably prompted by the loss of significant ground to Goldman Sachs, whose commodity index has become the commodities market equivalent of the S&P 500.

The Goldman Sachs Commodity Index (GSCI) is the index with the most money behind it. The reason is that the weighting calculations are done by the dollar volume of the commodities traded; the more trading activity in a particular commodity, the greater the weight in the index.

That causes the energy sector to have an unbelievable 69 percent weight in the index. Due to the large sums of money that follow the GSCI, the correlations between the different commodities have increased. The more money that flows into commodity index funds, the higher the correlations because those commodities are traded as baskets, simultaneously, according to their weight in the index.

The best way to follow the commodities markets with an index fund is through the Dow Jones-AIG Commodity Index. The components aren’t equally weighted, but the individual categories are. Energy comprises about a third of the index, metals account for another third and soft commodities are the final third. The individual commodities are then weighted within their respective sectors.

Commodities are as old as the hills, but commodity index funds available to individual investors are a new phenomenon. Not every commodity index discussed above can be followed with an index mutual fund, but luckily our favorite index can.

The PIMCO Commodity RealReturn Fund (NSDQ: PCRDX) follows the Dow Jones-AIG Total Return Index. Total return simply means that the collateral for the investments in commodities is then invested in interest-bearing securities. This adds an extra return kicker. The straight Dow Jones-AIG Index returned 4.6 percent in the first quarter, while the PIMCO fund returned 5.4 percent showing that it’s all in what benchmark you use.

Ben Shepherd is research editor of Bond Desk. Neil George is editor of Bond Desk.