What is the Alternative Minimum Tax and How Does It Affect You?
The alternative minimum tax or alt min tax (AMT) is a separate tax bill from your typical tax bill. The alt min tax is figured using a separate set of rates on Form 6251, Alternative Minimum Tax – Individuals. After filling out both your regular income tax return and the alt min tax form, if there is an alt min tax, you must pay both amounts. Unfortunately, AMT disallows certain deductions and exemptions allowed under federal and state tax rules. This is to ensure every taxpayer is paying their fair share of taxes.
Uncovering AMT history
In the 1960s, Congress noticed that a small not not insignificant number of wealthy individuals did not pay any income tax at all. These people took advantage of legal loopholes, deductions, and exemptions that reduced their tax liability to zero. Determined to avoid missing out on a major source of tax revenue, Congress enacted the alternative minimum tax, also known as alt min tax, in 1965. The purpose of the alt min tax was to ensure that wealthy taxpayers had no legal loopholes to jump through to effectively avoid paying taxes.
The first AMT generated $122 million, which is closer to $700 million by modern standards. Today, the AMT rakes in nearly $30 billion per year.
Fixing the alt min tax
The alt min tax had a major flaw: inflation rates rose while its exemptions and income thresholds stayed the same. With inflation making people feel more wealthy, the tax shifted from targeting the wealthy to absorbing taxes from middle-class families.
For decades, Congress passed a “patch” each year, manually raising exemptions and income thresholds to keep pace with inflation. Finally, in 2013, as part of the “fiscal cliff” showdown, Congress passed a law permanently indexing the alt min tax with inflation. Without the fix, millions of additional taxpayers would have been affected each year.
Understanding regular tax deductions and AMT deductions
The AMT disallows several regular tax deductions. These may include but are not limited to:
- Personal exemptions, such as the standard deduction or deductions for dependents
- State and local income or sales taxes
- Home equity interest used for anything other than home improvements
- Deductions for employee expenses or tax preparation fees
Some deductions are still allowed. These include charitable donations, above-the-line deductions, home mortgage interest, and business expenses for self-employed individuals. A few allowable deductions are adjusted to a lower rate.
Calculating the alternative minimum tax
You must use Form 6251 to determine your AMT. You will use this form in addition to Form 1040. Follow these steps:
- Start with your Adjusted Gross Income (AGI). Add or subtract any deduction adjustments, then add tax preferences, such as private-activity municipal-bond interest, drilling costs for oil and gas. Your total is your Alternative Minimum Taxable Income.
- Subtract the AMT exemption from your AMT income to determine your AMT base.
- Take the AMT base you calculated in Step 2 times your AMT tax rate. Your rate depends on your filing status and income. It will be either 26 percent or 28 percent. The result is your Tentative AMT
- Subtract any Foreign Tax Credits from your tentative AMT to get your final AMT.
- Subtract your regular tax from the AMT. If the result is positive, add the difference to Form 1040. If it is negative, you do not owe AMT.
When calculating AMT exemptions, the exemption is reduced by 25 cents for every dollar that your income exceeds the exemption.
Determining who pays alternative minimum tax
Income distribution in the United States covers a broad range of taxpayers, from very low incomes to very wealthy. Congress designed the alternative minimum tax to bypass the extremes on either end of this spectrum. This means people with higher income, but who are not extremely wealthy, are more likely to be affected.
There is no official income threshold or cutoff for the AMT. However, most financial Experts agree you should figure AMT if your pre-tax income is $75,000 or more. The Internal Revenue Service (IRS) has an AMT Assistant to help you determine whether you may owe alt min tax. The tool does not figure AMT for you. You must fill out IRS Form 6251 to determine how much you owe.
Surprisingly, some children owe an alt min tax. Children who are subject to the kiddie tax and have unearned income from investments may have to pay AMT. Be aware that the exemption amounts for these children are much lower than the AMT exemption for adult taxpayers.
Influencing factors for AMT
Nearly any taxpayer could be a candidate for AMT. The tax can have a greater impact on your return if you fit any of the following criteria:
- You claim itemized deductions and live in a state with high income, property or sales taxes
- You are married
- You have a big family
Factors like these usually have substantial tax exemptions or deductions associated with them. Unfortunately, tax breaks are disallowed when calculating AMT. Thus, your tax bill may be substantially higher.
The average tax liability with AMT is $2,000 - $15,000. About 62 percent of people who have a pretax income of $500,000 to $1 million must pay alternative minimum tax. Only about 40 percent of those who make between $200,000 - $500,000 annually must pay this tax. However, these individuals often have a larger tax bill.
Investing and the AMT
Investors may face the alt min tax at a higher rate because of capital gains, tax-free interest, tax shelters, and Incentive Stock Options (ISOs).
Long-term capital gains
Theoretically, these gains and dividends should not impact your AMT tax liability; they get the same tax breaks under both regular and AMT rules. In practice, substantial capital gains can reduce or wipe out AMT exemptions. These exemptions are designed to keep low-income taxpayers from paying alt min tax.
Some bonds such as municipal bonds are tax exempt under federal and state tax rules. However, because of the alt min tax, they may not receive the same exemptions. The tax laws governing bonds are complicated. Talk to a tax Expert to get advice and recommendations on bonds you own or considering purchasing.
A few types of investments still offer reduced tax liability. Many of these tax shelters involve drilling for fossil fuels. However, the AMT reduces the benefits that tax-sheltered investments offer. Your financial strategy should include how these types of investments can affect your liability under alt min tax.
Incentive Stock Options
ISOs also affect employees who decide to participate. Many publicly traded companies offer stock options to employees as part of their retirement planning packages.
Incentive stocks are frequently sold at prices below fair market value. Under regular tax rules, if you exercise ISOs, but do not sell the stock in the same year, you will not be taxed for the transaction. Under the alternative minimum tax, you get taxed on the possible profit you made. You must subtract the exercise price from the fair market value to determine your taxable profit.
For example, say you are offered 100 stock shares at $5 per share. The stock’s selling price that day is $30. Instead of selling it, you hold the options as a long-term investment. Under regular tax rules, your basis, or cost, in the stock is $500 (100 shares at $5 per share). Under AMT rules, your basis is $3,000 (100 shares at $30 per share), essentially wiping out the tax benefit of classifying a stock as a stock option.
Reducing AMT’s impact
One common adage advises that the best defense is a good offense. Planning ahead for AMT is essential to stay on top of your tax bill. Here are some tips for reducing your AMT bill.
Max out retirement contributions
If you have a 401(k) or a retirement plan that is similar, contribute the maximum amount each year. Since any contributions reduce your taxable income, they also lower your risk for getting hit with the AMT. The retirement vehicles you can contribute to in order to lower your overall tax footprint include:
- 401k: up to $18,000 annually for most individuals
- IRA: up to $5,500 annually for most individuals
- HSA: up to $3,350 annually for individuals with a high-deductible health plan
Maxing out tax-free or tax-deferred investments can help lower your taxable income by at least $25,000 each year, which has a direct impact on qualifying for the alt min tax.
Avoid pre-paying taxes
If you prepay your January tax bill in December thinking you are going to use it as a tax deduction, this could negatively affect alt min tax. If a taxpayer is subject to alt min tax, then the benefit of prepaying taxes in the prior year is gone. Alt min tax disallows prepaid tax deductions, so pay in the year property taxes are due.
Rethink how you use home equity
Standard tax rules allow you to use your home’s equity for purchases and get a tax break on interest. However, AMT rules only allow the tax break if you are buying or renovating a primary residence. Before using your home equity to finance another purchase, make sure you are aware of the tax implications.
Keep an eye on municipal funds
Some municipal funds advertise themselves as tax-free. This is true when your dividends are subject to regular taxes. However, bonds used for private activities like building a new stadium are taxable under AMT. If you already invest in municipal funds, check your 1099-DIV to see whether you have any distributions subject to AMT. Consider an AMT-free municipal fund as an alternative.
Pre-plan stock options
Hanging on to ISOs can be a great investment if you pay regular taxes. However, AMT rules are different, requiring you to pay taxes on the difference between the bargain price you paid and fair market value. If you are considering a significant investment, it is a good idea to review your options with a tax adviser. You want to profit from the transaction and have enough to cover the resulting taxes.
File Schedule C when possible
For self-employed taxpayers, filing deductions on a Schedule C will prevent deductions from being taxed by AMT. Many self-employed tax deductions get overlooked; however, deductions such as travel and office expenses can significantly reduce your tax bill. For the self-employed, prorating and claiming the percentage of property tax for a home office keeps often lowers the AMT.
Most tax preparation software will figure AMT for you, but the software does not tell you every qualified deduction. If you need help reviewing your return or planning for next year, ask a tax Expert for recommendations. They can point out deductions you missed or suggest options for future returns.