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Alternative Minimum Tax (AMT)

Congress created the AMT as an alternate form of federal income taxation to ensure that wealthy individuals and corporate taxpayers pay a fair share of federal income taxes. Its reach, however, now sometimes extends beyond the wealthy.

What is the AMT?

The AMT is a tax system that works in parallel with the regular federal income tax system—while some taxpayers use the regular system, others must use the AMT system. The AMT has its own set of forms, rates, rules, and brackets, and requires taxpayers to calculate their federal income tax using this system.

The AMT was originally designed to capture a small number of wealthy taxpayers and ensure that those taxpayers were paying at least a minimum amount of tax. Unlike the regular income tax, however, the AMT is not indexed for inflation. Thus, over time, inflation makes more and more taxpayers subject to the AMT, causing it to extend to more middle-income taxpayers.

Factors that can increase the likelihood of AMT

How can I find out if I may be subject to the AMT?

There are no guaranteed tests to determine in advance if you are subject to the AMT. If you were subject to it last year and you have a similar income and tax situation this year, you will most likely be subject to it again.

The IRS maintains a calculator, the IRS AMT Assistant, to help determine if you may be subject to the AMT. Another method is to see what you might owe under the ordinary tax system and compare it to what you might owe under the AMT. The TaxCaster can help you estimate both amounts. If your AMT tax bill is higher, that's the tax you'll owe.

Certain deductions and types of income can influence whether or not you are subject to the AMT. Among the most common factors that can make an individual subject to the AMT are substantial deductions for:

  • State and local income taxes.
  • Personal exemptions.
  • Interest on second mortgages and interest on home equity loans used for purposes other than home improvement.
  • Miscellaneous itemized deductions.
  • Medical expenses.

Note that these deductions have the potential to be disallowed or treated differently under the AMT system than under the normal ordinary income tax system.

Other factors that can cause susceptibility to the AMT are:

  • Earning significant interest income (usually tax-exempt) from certain private activity municipal bonds.
  • Exercising incentive stock options that are "deep in the money" (on which gain is usually deferrable and taxed as capital gain income).

If one or more of the above factors apply to you, consider talking to your tax advisor to see if you may be able to reduce your exposure to AMT.

If you are subject to the AMT, your tax bill could be significantly higher than it would be otherwise. Your tax bill could increase under the AMT in a number of ways, including:

  • You could lose deductions for state and local taxes paid.
  • You could lose the personal exemptions for yourself, your spouse (if you are married) and any children. For 2014, the personal exemption is $3,950. Thus, a married couple with three dependent children could lose $19,750 in exemptions in 2014.
  • If you don't itemize your deductions, you could lose the ability to claim the standard deduction. For 2014, the standard deduction is $12,400 for joint filers and $6,200 for singles.
  • If you have qualified dividends and long-term capital gains, they are taxed at federal rates no higher than 20% for purposes of both the ordinary income tax and the AMT. However, the extra income could reduce or even eliminate the amount of income you can exempt from the AMT. The AMT exemption amounts for tax year 2014 are:
    • $82,100 for married couples filing jointly
    • $52,800 for single and head of household filers
    • $41,050 for married couples filing separately
    In future years these amounts will be subject to adjustments due to inflation.
  • If you have certain private activity bonds that are not exempt from the AMT, they pay a slightly higher rate of interest to compensate for the lack of exemption. Therefore, if you are subject to the AMT, you'll have to include interest from these bonds as part of your taxable income.

If you are subject to the AMT, you will need to file Form 6251 and possibly other forms, depending on the nature of your income and deductions.

If you were subject to the AMT last year or you think you could be subject to the AMT in the future, you can take steps to help minimize its impact. Start your plan now by using the TaxCaster tool; it may help you estimate your potential tax liability under both the regular federal income tax system and the federal AMT system.

Although talking to your tax advisor about your specific situation is always advisable, below are four ways you may be able to reduce or perhaps even eliminate your exposure to the AMT.

1. Check your tax-free mutual funds and bonds

Interest income generated by most state and local municipal bonds is generally exempt from federal income tax and/or AMT.1 However, if these bonds were used to pay for such "private activities" as housing projects, hospitals, or certain industrial parks, the interest is fully taxable for taxpayers subject to the AMT.

Interest dividends distributed by a municipal bond or money market mutual fund are also subject to the AMT if the fund owns certain private activity bonds. A fund's prospectus will tell you if the fund aims to generate only AMT-free interest dividends. Fidelity offers both AMT-free municipal bond and money market funds that seek to avoid investing in any private activity bonds that generate interest dividends subject to the AMT.

2. Time deductions and tax payments

Let's say you aren’t likely subject to the AMT this year, but you discover that you may be subject to the AMT next year. You may want to consider paying your local and state tax bills (including property tax) before the end of this year. You could also group together other expenses for next year—such as interest on a second mortgage and investment and tax preparation fees—and pay them this year. You'll gain deductions that may otherwise be lost next year, and you may be able to avoid AMT in the current year.

3. Time your capital gains

Under the AMT, a portion of your income may be exempt from tax. For the 2013 tax year, the exemption amounts will be $80,800 for married joint filers and $51,900 for unmarried individuals, but the exemption is subject to phase-out based on income. While capital gains generally qualify for the same lower rates under the AMT as under the regular tax rules, a capital gain may cause you to lose part or all of your AMT exemption.

If you hold securities that are not publicly traded, you may be able to manage this situation by delaying a sale into the next year or using an installment sale2 to spread the gains and potential tax liability over a number of years.

For example, if you have appreciated private securities that would result in a $50,000 capital gain, you might consider spreading the sale out over two to three years, especially if you have other non-recurring deductions that you want to use. Before taking any action, however, be sure to take into account your long-term financial plans.

4. Be careful with incentive stock options

Typically, you don't have to include income related to the exercise of incentive stock options (ISOs) when calculating your normal tax liability. With the AMT, you must often include ISO income when you exercise the options, regardless of how much longer you hold the shares received. If you are likely to pay the AMT, consider selling your shares in the same year you exercise the options. That way, you'll at least have the cash to pay your AMT bill. You could also think about exercising a few options at a time over several years to spread out the income and potential tax liability.

Consult your tax professional for guidance appropriate to your specific situation on these and other strategies for managing your AMT exposure.

Additional resources

Mutual Funds and Taxes
Understand how distributions from mutual funds are handled on your tax return.

1. Municipal bond funds normally seek to earn income and pay dividends that are expected to be exempt from federal income tax. If a fund investor is resident in the state of issuance of the bonds held by the fund, interest dividends may also be exempt from state and local income taxes. Such interest dividends may be subject to federal and/or state alternative minimum taxes. Investing in municipal bond funds for the purpose of generating tax-exempt income may not be appropriate for investors in all tax brackets. Interest dividends paid by Treasury bond funds are generally exempt from state income tax but are generally subject to federal income and alternative minimum taxes and may be subject to state alternative minimum taxes. Fund shareholders may also receive taxable distributions attributable to a fund's sale of municipal bonds. Fund redemptions, including exchanges, may result in a capital gain or loss for federal and/or state income tax purposes.
2. The installment sale method cannot be used for sales of securities traded on an established securities market.

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