The alternative minimum tax (AMT) has been a source of angst for an increasing number of taxpayers ever since its inception in 1969.
You still need to calculate your tax liability under the ordinary tax system and under the AMT, and pay whichever bill is higher.
What is the alternative minimum tax?
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 alternative minimum tax in the first place—but the AMT remained in the law, perhaps because it accounts for billions of dollars in extra tax revenues every year.
Because the alternative minimum tax disallows a number of deductions that are allowed in the ordinary income tax code, people who benefit most from those ordinary income-tax deductions (such as people with large families, married couples, and people who pay high state and local taxes) are those who are likelier to get hit with the AMT. It's not unusual for single taxpayers in a low-tax state with over $500,000 of ordinary income to escape the brunt of the alternative minimum tax, while a couple with children making a combined salary of $200,000 gets hit.
How the alternative minimum tax 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.
Here is a simplified example of how the AMT works (for the real deal, see IRS Form 6251):
- Compute 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 personal and dependent exemptions.
- Add back any deductions that are not allowed for the AMT.
- Subtract your AMT exemption, if you're eligible. For the 2014 tax year, the exemption is $82,100 for married couples filing jointly and $52,800 for single filers.
- Compute your alternative minimum tax on what's left—the AMT rate is 26% on the first $175,000 for both singles and married filing jointly and 28% on anything over that.
- Compare the amount due under the ordinary tax and the AMT. Pay whichever amount is higher.
Planning for the AMT
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 tax planning tools. 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.
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. AMT calculations require you to add back in the standard deduction, but charitable and medical deductions are among the few that are allowed under the AMT.
- 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 December 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, which fund private company projects that benefit the public (such as airports, for example). Interest from these bonds is generally tax free under ordinary income tax rules but not the 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. Usually, you aren't taxed until you sell a stock, at which point you pay capital gains on the difference between what you paid for the stock (the exercise price) and what you sold it for. But the AMT system looks at the difference between the exercise price and the fair market value of the stock at the time you exercise incentive stock options (the “spread” is taxed as ordinary income for non-qualified stock options). So if you plan on holding the stock after exercise, run some projections to see if there's a point at which you enter AMT territory.
- Sometimes, it may make sense to take in extra ordinary income in the year of an ISO exercise. Taking in extra ordinary income (in the form of short-term capital gains, for example) could be attractive if you can recognize the income at the 28% AMT rate as opposed to what would otherwise be a higher ordinary rate in a year you aren't in the AMT system. 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, which would cause your gains to be treated as ordinary income.
- If you plan on holding the stock, consider exercising ISOs earlier in the year. Exercising ISOs earlier in the year 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.