AMT: The Alternative MAXIMUM Tax

Tax Article

Charles Schwab & Co., Inc.

Call us at 866-232-9890

Send us an email

Printer-friendly
Type Size: A A A
Email to a friend

AMT: The Alternative MAXIMUM Tax
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
Updated October 15, 2008

If you're one of the growing millions of taxpayers caught in the labyrinth of the dreaded alternative minimum tax, the word "minimum" may strike you as a misnomer. "Maximum" might seem more appropriate, since running afoul of the AMT typically means paying more in taxes, not less.

What is the AMT? How does it work? What you can do about it?

You should care about these questions even if you haven't yet been stung by the AMT—the way things are going, it may only be a matter of time.

What is the AMT?
There are two parallel income tax systems in the United States: ordinary income tax and alternative minimum tax. Taxpayers must calculate their tax under each system, then pay whichever is higher—ordinary or AMT.

Congress introduced the AMT in 1969, having decided that certain wealthy individuals weren't paying enough tax because of various loopholes. In 1986, the entire Internal Revenue Code was overhauled, eliminating virtually all the loopholes that prompted the introduction of the AMT in the first place, but the AMT remained in the law. In fact, the rules have changed so much that today it's not unusual for taxpayers with over $500,000 of ordinary income to escape the AMT, while a couple with children making $150,000 in combined salary gets whacked.

Despite the AMT's obsolescence, inequities and complexity, Congress has resisted efforts to repeal or even reform the AMT system. Instead it prefers to patch over the problem with temporary fixes that continue to fall short. But with the AMT affecting more and more middle-class taxpayers, serious reform may only be a matter of time. Why the ticking time bomb? Unlike the ordinary income tax system, the AMT has never been adjusted for inflation.

How the AMT works
The AMT requires you to include income from certain sources that ordinary income tax lets you exclude—for example, interest from private activity municipal bonds and the spread on the exercise of incentive stock options.

Then, the AMT system takes away certain tax breaks, including:

Your personal exemption
Dependent exemptions
Deductions for state and local taxes paid
Deductions for interest on home equity loans not used to improve your home
Miscellaneous itemized deductions.

If you don't itemize your deductions, you're still not out of the woods. The AMT also snatches away the regular standard deduction. There is an AMT exemption, but it phases out if alternative minimum taxable income (AMTI) is above $112,000 for single filers or $150,000 for married filing jointly ($75,000 for married filing separately).

Those income limits may seem high, but the main problem with the AMT exemption is that it's pretty small to begin with. For decades, the AMT exemption remained at a paltry $33,750 for single filers and $45,000 for married filing jointly. In 2001, Congress gave those amounts a meager raise to $35,750 and $49,000, but that was only meant to last through 2004. The 2003 tax act again gave temporary (and minor) relief by raising the exemptions to $40,250 and $58,000 respectively through 2005. Since then, Congress has applied temporary extensions to keep from reverting to the older, lower limits. Most recently, Congress extended slightly higher limits for the 2008 tax year—$69,950 for married filing jointly and $46,200 for single filers. After that, we're set to go back to the pre-2001 levels unless Congress slaps on yet another short-term patch or makes AMT reform more permanent.

Here is an overly simplified example of how the AMT works (for the real deal, see IRS Form 6251):

Compute your ordinary taxable income.
Add back the personal and dependent exemptions you were allowed to subtract when computing your ordinary taxable income.
Add the income from sources you didn't have to include for ordinary income tax, but which are taxable under the AMT.
Add back any deductions subtracted from income for ordinary purposes but are not allowed for the AMT.
Subtract your AMT exemption, if you're eligible, and compute your AMT on what's left—the AMT rate is 26% on the first $87,500 for singles or $175,000 for married filing jointly ($87,500 for married filing separately) and 28% on anything over that.
Compare your ordinary tax due and your AMT due. Pay whichever amount is higher.

Planning for the AMT
The most recent extension of higher income limits likely spared an additional 20 million taxpayers from having to pay AMT in 2008. Assuming no further changes to the AMT system, projections show the number of taxpayers affected jumping to over 30 million by 2010—that's around one in three taxpayers. What's more, while people earning between $100,000 and $200,000 will probably be hit hardest, a significant portion of those earning between $75,000 and $100,000 are likely to join the AMT ranks as well.

Unfortunately, there's no easy way to figure out whether the AMT will be a problem for you. Each case is different and it's a good idea to run your own projections using tax preparation software. Schwab clients can log in to use the tax planning tools available on Schwab.com. Or, hire a tax professional to run projections for you.

Because you may find yourself in the AMT system one year but not the next, multi-year projections are a must for smart tax planning. For example, a multi-year analysis would be standard operating procedure if you're looking to develop an optimal exercise-and-hold strategy for incentive stock options, or if you want to get the most bang for your buck when it comes to the timing of certain deductions and/or income.

What can you do about the AMT, besides writing your representatives in Congress? If you're in AMT territory or close to it, here are a few actions to consider:

Even if your itemized deductions total less than the standard deduction, you may be better off taking the itemized deductions if it means staying out of the AMT system. Strange as it seems, this might be the case if you have significant charitable or medical deductions. You'd lose the standard deduction for the AMT, but get to keep certain itemized deductions—and come out ahead.
If you're in the clear this year but expect to get hit by the AMT next year, it might be a good idea to pay all or some of your estimated state income tax and/or local property taxes by Dec. 31 instead of in January. The same applies in reverse: If you're already in the AMT system this year and you won't benefit from additional itemized deductions for state and local taxes anyway, wait until the first part of next year to pay.
Watch out for private-activity municipal bonds. Interest from these bonds is tax free under ordinary income tax rules but not AMT rules. You should be able to find a suitable, alternative municipal bond that will be tax free for both ordinary and AMT. For muni-bond mutual funds, check the prospectus for the fund company's policies on private activity bonds.
When projecting the after-tax cost of a home equity loan or line of credit, don't forget the interest deduction is disallowed for under the AMT if the loan will be used for something other than capital improvements to your principal or secondary residence.
Be careful with the timing of long-term capital gains. Long-term gains are taxed at the same rate for both regular and AMT purposes, but the additional capital-gain income could put you over the AMT exemption threshold, triggering additional AMT. Also, state income tax paid on capital gains is not deductible under the AMT rules.
Exercise incentive stock options (ISOs) with care. If you plan on holding the stock after exercise, run some projections to see if there's a break-even point at which you enter AMT territory. You also might be able to eliminate the AMT by exercising non-qualifying stock options (NQSOs) or disqualifying a portion of your ISOs in the same year. This could be especially attractive if you can recognize income at the 28% AMT rate that would otherwise be taxed at a higher ordinary rate in a year you aren't in the AMT system. It's also generally better to exercise ISOs earlier in the year if you plan on holding the stock, since it gives you more time to contemplate a same-year disqualifying disposition (which will avoid AMT treatment). If you do end up owing AMT on an ISO exercise, you may be entitled to an AMT credit in a later year. To claim it, be sure to keep track of your dual cost basis—the exercise price for ordinary capital gains tax purposes and the fair market value at the time of exercise for AMT capital gains tax purposes.
Check with your tax professional regarding limited partnerships and rental real estate. If you're involved in passive activities like these, especially where asset depreciation is involved, the rules become increasingly complex.
If you receive a refund for state income taxes paid in a prior year when you were in the AMT system, be careful you don't include the refund as ordinary taxable income if you received no past benefit for the deduction.

The bottom line
If all this seems overwhelmingly convoluted to you, you're not alone. Even Albert Einstein is said to have remarked, "The hardest thing to understand in the world is the income tax." And just think, that was before the invention of the AMT!

Be sure to enlist the help of a tax professional if you're concerned about alternative minimum tax. Meanwhile, if you're among the one in three taxpayers who will become part of the AMT "elite" over the next few years, you can always let off some steam by writing your representatives in Washington, D.C.

Important Disclosures

Individuals should contact their own professional tax advisors or other professionals to help answer questions about specific situations or needs prior to taking any action based upon this information.

The information presented does not consider your particular investment objectives or financial situation and does not make personalized recommendations. This information should not be construed as an offer to sell or a solicitation of an offer to buy any security. The investment strategies and the securities shown may not be suitable for you. We believe the information provided is reliable, but Charles Schwab & Co., Inc. ("Schwab") and its affiliates do not guarantee its accuracy, timeliness, or completeness. Any opinions expressed herein are subject to change without notice.

(1008-8908)

Return to Top