Now's the Time to Tweak Your Portfolio

Physician's Money Digest, September15 2003, Volume 10, Issue 17

The new tax legislation, which has reduced taxrates across the board, is providing many taxpayerswith relief. This relief will be compromised,however, for a large number of high-incometaxpayers thanks to the alternative minimum tax(AMT), which taxes ordinary income at a 28% rate.If these high-income taxpayers are not caught by theAMT this year, odds are they will be over the next fewyears. In fact, according to the Urban-Brookings TaxPolicy Center (www.taxpolicy.org), by 2010 at least 35million Americans will have to pay the AMT—that'smore than one third of all taxpayers.

Tax Facts

IRS warning

The AMT was designed 30 years ago to ensure thatthe top 2% of US taxpayers made at least a minimumtax payment on their income. But under the new tax bill,even more taxpayers will be snared by the AMT, includingtaxpayers with annual incomes as low as $50,000.: The AMT is usually triggered by a combinationof disallowed deductions and exemptions.

In 2003 and 2004, Congress is offering some AMTrelief. For married couples, the amount of income shieldedfrom the AMT has increased from $49,000 to$58,000. Even so, high-income professionals in high-taxstates, such as New York, Massachusetts, and California,are increasingly vulnerable to the AMT.

There are a few strategies available to investors whowant to avoid the AMT. Tax-sensitive equity funds lookto minimize tax consequences by avoiding dividend-payingstocks and offsetting gains with losses. However, notall funds are successful at limiting taxable returns.Indeed, 2000 and 2001 saw notable examples of high,taxable distributions from tax-managed equity funds.

Bond Options

On the bond side of the equation, there are a fewoptions. In most cases, bonds generate ordinary income(unlike equities, which generate capital gains), and ordinaryincome, of course, is taxed at a higher rate.Therefore, most investors and their advisors have adoptedthe strategy of investing in tax-free municipal bonds.

The portfolio shuffle:

For fixed-income investors who are subject to theAMT, however, taxable income should be consideredan attractive investment when the after-tax yields onthe taxable bonds exceed the tax-exempt yields availablein the municipal market. This is accomplished by repositioning a portion of aninvestor's fixed-income portfolio from municipalbonds to taxable bonds.

The goal is to construct a fixed-income portfoliothat generates the highest after-tax returns based onan investor's tax circumstances. To accomplish thisgoal, start by considering your tax rate and the likelihoodof paying the AMT. Then compare returns to seewhich sectors in the bond market afford the greatestafter-tax value, paying particular attention to municipalbonds that are tax-free, municipal bonds that aresubject to the AMT but pay higher interest, and taxablebonds that pay high interest.

Investor beware

In today's low-interest-rate environment, themunicipal market remains at historically attractivelevels compared to most of the taxable sectors, andtherefore represents the most attractive fixed-incomesector for most taxpayers, including those subject tothe AMT. : The relationship betweenthe municipal market and the taxable market changessuddenly and dramatically.

Finding the best bond mix is a complicated andinexact science. There are no off-the-shelf solutionsfor investors (eg, there are no mutual funds availablethat take into consideration AMT implications).Therefore, it's a good idea for investors who want toconstruct a bond portfolio to consider hiring a financialadvisor. Their experience can help you choose theright bonds for your portfolio.

Ronald J. Sanchez is senior VP and head of theMunicipal Fixed-Income Group for FiduciaryTrust Company International in New York City.He welcomes questions or comments at 212-312-3316 or rsanchez@ftci.com. This article is notintended to provide financial or tax planningadvice. You should consult with your financial,tax, and legal advisor before making any investment.