Nobody enjoys paying taxes, but if you had to pick one tax that is almost universally disliked, it's the alternative minimum tax (AMT). Fortunately, recent tax-law changes have kept more taxpayers from falling into AMT territory—but those changes could revert in a few years. In the meantime, it's still useful to know how the alternative minimum tax is calculated and how it could affect you.
What is the alternative minimum tax?
The easiest way to understand the AMT is to envision it as a tax floor. Once your tax rate drops to that floor, the AMT won't allow it to go any lower.
Originally, the AMT was intended to crack down on wealthy people who weren't paying any income taxes. Gradually, as inflation caused incomes to rise, the middle class started to get hit with this tax.
When Congress passed the Tax Cuts and Jobs Act (TCJA) in December 2017, the AMT rules significantly changed. However, the changes are temporary and apply only to tax years 2018 to 2025 unless Congress extends them or makes them permanent.
How does the alternative minimum tax work?
Let's look at a simple example.
Be sure to include income that might be tax-free under the normal income tax system but not under the AMT. One example is interest from private-activity municipal bonds, which fund private company projects that benefit the public (like airports).
Next, remove certain tax breaks, such as your deductions for state, local, and property taxes.
Then, subtract your AMT exemption (if eligible), which for the 2022 tax year is $75,900 for individuals, $59,050 for married couples filing separately, and $118,100 for married couples filing jointly or qualifying widow(er).
Finally, compute the AMT on what's left, compare that amount with what you would owe under the regular system, and pay the higher of the two.
What are the chances the alternative minimum tax will affect you?
Prior to the passage of the TCJA (tax years 2017 or earlier), if your household income was over $200,000 per year, you had about a 56% chance that the AMT would show up on your tax return.¹ With those odds, many people were rightfully concerned about the AMT affecting them.
Today, your odds of encountering the AMT are much lower, primarily because of two significant changes within the TCJA: an increase in the AMT exemptions and an increase in the phase-out thresholds. The chart below compares the prior AMT exemption to the current exemption under the TCJA.
Along with the increased exemption, the point at which the exemption begins to phase out has been significantly increased.
Once your income for the AMT hits the phase-out threshold, your AMT exemption begins to phase out at 25 cents for every dollar over the threshold. In the past, the phase-out level was quite low, and many households that wouldn't consider themselves to be wealthy were getting affected by the AMT.
What triggers the alternative minimum tax for tax years 2018 to 2025?
These are some of the most likely situations:
- Having a high household income. If your household income is over the phase-out thresholds ($1,079,800 for married filing jointly and $539,900 for everyone else), and you have a significant amount of itemized deductions, the AMT could still affect you.
- Realizing a large capital gain. Long-term gains (e.g., profits from selling a home or other investments) are taxed at the same rate under both systems, but capital gains could put you over the AMT exemption threshold. That could cause the AMT to kick in, which means you may not be able to deduct state income taxes you paid.
- Exercising stock options. Normally, exercising qualified employee stock options (also called incentive stock options or ISOs) to buy stock at a discounted price isn't a taxable event until you sell the shares for a profit. The AMT, however, creates a paper profit that's taxable even though you won't receive the actual profit until you sell the shares.
If you're close to the AMT thresholds, you can use IRS Form 6251 to see if you're at risk. You can also run your own projections using tax preparation software or hire a tax professional to calculate it for you.
Depending on your income and deductions, you could find yourself affected by the AMT in one tax year but not the next. If you're close to the AMT threshold, doing a multiyear projection is good practice to see which tax years pose the most risk for you and how you might mitigate that risk. For example, you could accelerate or delay certain transactions, such as selling an asset with a large gain, to minimize triggering the AMT.
Getting hit with the AMT is unfortunate, but it's not a reason to change your life goals. The AMT is just something to be aware of during your financial planning process—it shouldn't keep you up at night.
¹Source: Schwab Center for Financial Research, based on information in the IRS publication "Statistics of Income–2014 Individual Income Tax Returns Complete Report" (Publication 1304), Table 1.4.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Tax laws are subject to change, either prospectively or retroactively. 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 provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
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