We are now solidly into 2014, so it's time to start thinking about your 2013 tax bill. One big question to be answered is whether you will owe the dreaded alternative minimum tax with your 2013 Form 1040.
Congress originally cooked up the alternative minimum tax (AMT) to make sure high-income types who take advantage of multiple tax breaks would still owe something to Uncle Sam each year. These days, however, upper-middle-income folks are the most likely AMT victims. Here's what you need to know.
Think of the AMT as a separate tax system with a family resemblance to the more-familiar "regular" federal income tax system. The difference is the AMT system taxes certain types of income that are tax-free under the regular tax system and disallows some regular tax deductions.
Also, the maximum AMT rate is "only" 28% versus 39.6% under the regular tax system. Finally, you're allowed a relatively generous AMT exemption, which is equivalent to a deduction when calculating the AMT. For 2013, the exemption is $80,800 for married joint-filing couples and $51,900 for unmarried folks.
Unfortunately, the exemption is phased out when your AMT income gets too high. If your AMT bill exceeds your regular tax bill, you must pay the higher AMT amount.
Causes of AMT exposure
Interacting factors make it difficult to pinpoint precisely who will be hit by the AMT and who won't. But here are the danger signs.
- Your income is high enough (say $250,000 or more) that a good part or all of your AMT exemption is phased-out.
- You have relatively hefty deductions for state and local income and property taxes under the regular tax rules (say $20,000 or more). These deductions are disallowed under the AMT rules.
- You have a spouse and several kids which translates into four or more personal and dependent exemption deductions under the regular tax rules. These deductions are disallowed under the AMT rules.
- You exercised one or more in-the-money incentive stock options (ISOs). The so-called bargain element (the difference between the market value of the shares on the exercise date and the ISO exercise price) does not count as income under the regular tax rules, but it does count as income under the AMT rules.
- You have a significant deduction for home equity mortgage interest. Under the regular tax rules, you can deduct the interest on up to $100,000 of home-equity loans. But under the AMT rules you can only deduct interest on loan balances of up to $100,000 that are used to acquire or improve your first or second residence.
- You have write-offs for miscellaneous itemized deduction items (such as investment expenses, fees for tax advice and preparation, and unreimbursed employee business expenses) under the regular tax rules. These deductions are disallowed under the AMT rules.
- You have business depreciation write-offs for personal property assets such as machinery, equipment, computers, furniture, and fixtures used in a sole proprietorship or a partnership, LLC, or S corporation in which you own an interest. These assets must be depreciated over longer periods under the AMT rules, so a portion of your regular tax deductions are disallowed for AMT purposes.
- You have private activity bond interest which is tax-free under the regular tax rules but taxable under the AMT rules.
If you have one or more of these exposure items, you should first estimate your regular federal income tax liability. Then estimate your AMT liability by filling out IRS Form 6251 (Alternative Minimum Tax—Individuals). If your AMT bill exceeds your regular tax bill, you will owe the AMT.
Why upper-middle-income taxpayers get hit
Under our current tax rules, the AMT is usually a nonfactor for folks with really high incomes (say $750,000 or higher) for two main reasons.
- First, their marginal regular federal income rate will be 39.6% while the maximum AMT rate is "only" 28%. So the regular tax bill for a person with really high income is likely to exceed the AMT bill. On the other hand, folks in the upper-middle-income zone may have enough regular tax deductions that they pay an average regular tax rate that's lower than the AMT rate. If so, they will owe the AMT.
- Second, many tax breaks for folks with really high incomes are already cut back under the regular tax rules before even getting to the AMT calculation. For instance, the passive activity loss (PAL) rules greatly restrict tax benefits from traditional tax-shelter investments like rental real estate and limited partnerships. And if your income exceeds certain limits, you'll run into regular tax phase-out rules that chip away or eliminate your personal and dependent exemption deductions, your biggest itemized deductions, and your tax credits. So you may have little or nothing left to lose under the AMT rules. In contrast, folks in the upper-middle-income zone often have lots to lose, such as significant deductions that are allowed for regular tax purposes but disallowed under the AMT rules. As a result, they wind up owing the AMT.
Planning ahead to avoid or minimize the AMT
Sadly, it's too late to do much to avoid the AMT for last year. However, there are some things you can do to avoid it for this year and beyond.
Any move that reduces your adjusted gross income (AGI) might help avoid the AMT. AGI is the number at the bottom of page 1 of your Form 1040. It includes all your taxable income items and is reduced by certain deductions such as the ones for alimony paid to an ex-spouse and moving expenses. Lower AGI means a better chance of claiming a bigger AMT exemption which will reduce your AMT exposure. Here are some ways to cut your AGI.
- Make a deductible IRA contribution if you qualify. If you qualify for a 2013 deductible contribution but have not yet made it, this is one thing you can still do to lower your 2013 AMT bill. The contribution deadline is 4/15/14.
- Contribute the max to your tax-deferred retirement plan at work (typically a 401(k) plan).
- Contribute more to your cafeteria benefit plan and health care and dependent-care flexible spending accounts (FSAs) at work. The contributions will lower your taxable salary, which lowers your AGI and your exposure to the AMT.
- Prepay deductible business expenses near year-end if you run a business as a sole proprietorship, LLC, partnership, or S corporation. The deductions are "passed through" to you, resulting in lower AGI and less exposure to the AMT. Similarly, postponing the receipt of taxable income until next year will also reduce your exposure.
- Consider selling some loser investments held in taxable brokerage firm accounts. You can use the capital losses to offset capital gains, which reduces your AGI and your exposure to the AMT. Any leftover capital losses up to $3,000 are deductible against taxable income from all sources. So your AMT exposure is reduced even further.
- Consider deferring securities sales that will produce taxable gains until next year.
Finally, please carefully time the exercise of any in-the-money ISOs. Triggering these options when there's a big bargain element is one of the most common causes of AMT hits.
The bottom line
Don't just blithely assume the AMT doesn't apply to you. If you have the risk factors listed earlier, you could be among the many unsuspecting folks who will owe the tax with their 2013 returns. To find out for sure, you must fill out Form 6251 (Alternative Minimum Tax—Individuals) when preparing your return. If you fail to pay and get nailed by the IRS, you'll owe back taxes, interest, and maybe penalties to boot. Not good!