What’s a bigger pain than calculating your tax bill? Calculating it twice. Yet that’s precisely what millions of taxpayers are forced to do every year because of the alternative minimum tax (AMT).
The infamous AMT, established in 1969, was designed to prevent high-income individuals from avoiding income tax by piling up deductions. Yet the number of taxpayers caught by the tax has increased dramatically over the years, hitting more middle- and upper-middle-income families. For the 2012 tax year, approximately 4 million taxpayers were expected to pay the AMT, up from 1.3 million taxpayers in 2001.1
Taxpayers finally got some good news regarding the AMT when Congress enacted a permanent “patch,” indexed for inflation, that is designed to limit the reach of the AMT. The provision, which was part of the “fiscal cliff” legislation passed on January 1, 2013, will prevent the annual nail-biting ritual of waiting for Congress to extend the patch one year at a time—and save an additional 28 million taxpayers from the AMT’s snare.1 But it won’t change the fact that the AMT creates headaches for many taxpayers.
Managing your taxes to avoid or minimize the AMT is difficult but not impossible. With careful management of your deductions and income, you could potentially reduce your exposure to the tax. The place to start formulating your AMT strategy is with an understanding of what the tax is and how likely you are to be affected.
AMT red flags
The AMT is essentially a parallel method for calculating your income tax. First, you calculate how much tax you would owe under the standard method, with all the deductions and credits that most of us are accustomed to. Then, you go through the process again using the AMT method of “add backs,” which removes certain tax breaks, adds certain income, and applies a separate, two-tiered tax rate.
The larger of the bottom-line numbers produced by the separate methods is the amount of tax you owe. If you use tax preparation software or a tax service, you might be unaware of this process, but it’s taking place behind the scenes.
While the AMT method can seem like a black box to the average taxpayer, there are indicators of AMT exposure. Some of the biggest reasons that taxpayers are subject to the AMT include:
High state and local taxes. When figuring the AMT, the deductions for nonfederal tax payments you were able to claim on Schedule A are disallowed. In addition to state and local income taxes, these deductions include real estate taxes and personal property taxes. Because of this, taxpayers in high-tax states were about 2.5 times as likely as those in low-tax states to have owed the AMT in 2011.2
Big family. If you have a lot of dependents, you’re more likely to be hit by the AMT. That’s because the tax doesn’t allow you to subtract your personal exemptions (number of dependents times $3,800 in 2012, $3,900 in 2013). Taxpayers with three or more children were almost three times more likely than those with no children to owe the AMT in 2011.2
Incentive stock options. Under the AMT, the difference between the lower grant price of an incentive stock option (ISO) and the higher value of the stock on the day of the exercise is considered current-year taxable income. For regular tax purposes, you don’t owe taxes on stock you purchased until you actually sell it. This difference may result in a huge AMT exposure for people with ISOs for stock that has increased significantly in value.
Interest on home equity loans. The AMT does not allow you to deduct interest on a home equity loan that was used for anything other than making an improvement to your home. If you used the loan to buy a car or pay college tuition, you lose the deduction.
Among other deductions the AMT throws out or reduces are medical expenses, “miscellaneous” items like interest income from private-activity bonds (including those held in bond funds), business operating losses, small-business stock sales, estate or trust income, depreciation, and passive activities.
What to do?
Carefully evaluate your AMT exposure year by year in order to take advantage of opportunities to reduce exposure to the tax when it makes sense. Below are some areas of focus to consider when examining your potential AMT exposure:
Review your AMT exposure in previous years. Look at Form 6251, lines 1–27. If you were subject to AMT in previous years, you’ll be able to see which items were responsible. If you didn’t pay any AMT previously, you can see how close you came and compare the old numbers to any new AMT exposure in the current year or upcoming years.
Lower your adjusted gross income. Because the starting point for calculating the AMT is your adjusted gross income on Form 1040, you can reduce your exposure by maximizing your contributions to a tax-deferred vehicle, such as a 401(k), 403(b), IRA, or health savings account.
Reduce your AMT add-backs. Among the possibilities, consider AMT tax-free bond funds. Consider deducting a portion of your real estate taxes as a home office expense, if you can. Ask your employer to reimburse you for business expenses rather than having to claim them as a miscellaneous tax deduction.
Time your state and local tax payments and capital gains. If you anticipate being subject to the AMT one year but not the next, you might be able to double up your state and local tax payments in the non-AMT year. Also pay attention to capital gains. Although they are not taxed at AMT rates, capital gains are included in AMT income and therefore could cause you to be subject to the phaseout of the AMT exemption—in effect, increasing your capital gains tax rate. To avoid this situation, it may make sense to spread your taxable gains over a number of years through an installment sale, depending on the nature of the asset. On the other hand, if you’re close to the AMT phaseout threshold, you don’t want to turn a one-year hit into multiple years of increased AMT liability. Crunch the numbers with the help of a tax professional.
Manage your ISOs. Before exercising ISOs—or even if you already have—you should consult a tax professional. ISO strategies can be quite complex. One simple way to negate the potential AMT impact would be to sell your ISO-purchased stock in the same year you bought it, but that has some potential downsides, too, which could outweigh having to pay the AMT. If you do pay AMT on an ISO, don’t forget that you can claim an AMT credit in subsequent years when you don’t owe any AMT. However, there are limitations on when you can use an AMT credit.
Protect yourself from penalties. To add insult to injury, you could owe a penalty if an unexpected AMT liability causes you to underpay your federal tax by more than 10%. This is often a concern for self-employed people and retirees who make quarterly estimated tax payments. One way to potentially avoid the penalty is to ensure that your estimated payments and withholding are at least as much as last year’s tax.
Be prepared. Even if you can’t avoid the AMT in a given year, you can at least try to anticipate what’s coming. The IRS has created an AMT Assistant calculator to help you assess your exposure. Also, Fidelity offers free use of Intuit’s TaxCaster to help you estimate your taxes (AMT and regular).
The AMT can be a headache for millions of taxpayers. The best remedy is to pay close attention to your exposure, employ smart tax strategies where you can, and get help through a knowledgeable tax professional or trusted tax software.