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The AMT and you

With careful management of deductions and income, you may be able to reduce exposure to the tax.

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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.

Managing your taxes to avoid or reduce your AMT exposure is difficult but not impossible. With careful management of your deductions and income, you could potentially reduce your exposure to the tax. To start formulating your AMT strategy, begin 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 hole to the average taxpayer, there are indicators of potential AMT exposure. Some of the biggest reasons 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.
  • 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 $4,000 in 2015, $4,050 in 2016).
  • 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've 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 sometimes throws out or reduces involve medical expenses, interest income from private-activity municipal bonds (including those held in municipal bond funds), certain business operating losses, small-business stock sales, estate and trust income, depreciation and depletion, and passive activities.

What to do?

With careful management of your deductions and income, you could potentially reduce your exposure to the tax.

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 focus areas to consider when examining your potential AMT exposure:

1. 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 with any new AMT exposure in the current year or upcoming years.

2. 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 (HSA).

3. Reduce your AMT add-backs.

Among the possibilities, consider AMT tax-free bond funds. Also, consider deducting a portion of your real estate taxes as a home office expense, if you can.

4. 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.

5. 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 doing so 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. Note that you’ll owe the AMT even if the stock’s price declines after you exercise the option but before you sell the stock. That can leave you owing taxes on a large gain even though the stock price declined. Be aware of the risks if you choose to exercise ISOs and not immediately sell the underlying stock.

6. 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.

7. Be prepared.

Even if you can’t avoid the AMT in a given year, you can at least try to anticipate what’s coming. Use the IRS Alternative Minimum Tax 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.

Learn more

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Before investing, consider the funds’ investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

Interest income earned from tax-exempt municipal securities generally is exempt from federal income tax and may also be exempt from state and local income taxes if you are a resident in the state of issuance. A portion of the income you receive may be subject to federal and state income taxes, including the federal alternative minimum tax. You may also be subject to tax on amounts recognized in connection with the sale of municipal bonds, including capital gains and “market discount” taxed at ordinary income rates. Market discount arises when a bond is purchased on the secondary market for a price that is less than its stated redemption price by more than a statutory amount. Before making any investment, you should review the relevant offering's official statement for additional tax and other considerations.

The municipal market can be adversely affected by tax, legislative, or political changes, and by the financial condition of the issuers of municipal securities. Investing in municipal bonds for the purpose of generating tax-exempt income may not be appropriate for investors in all tax brackets or for all account types. Tax laws are subject to change, and the preferential tax treatment of municipal bond interest income may be revoked or phased out for investors at certain income levels. You should consult your tax advisor regarding your specific situation.

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