The alternative minimum tax (AMT) has been called the stealth tax, and with good reason: Although intended for the rich, the AMT is affecting more and more middle-income Americans in large part because it has only been adjusted for inflation twice since its introduction in 1969. Although Congress has implemented various AMT patches over the years, the tax has not really been indexed for inflation, and as of 2011, an estimated 4.3 million taxpayers were subject to the alternative minimum tax.
The bottom line is that this tax was meant for the very rich, but because of unadjusted thresholds, it's hitting a lot of those who earn just above the national average. A general understanding of how the tax works may help you avoid it.
The Other Income Tax
The AMT truly functions as an 'alternative' federal tax system. It has its own set of rates and rules for deductions, which are more restrictive than the regular rules. It operates in parallel with the regular income tax system in that if you're already paying at least as much under the 'regular' income tax as you would under AMT, you don't have to pay it. But if your regular tax falls below this minimum, you have to make up the difference by paying the alternative minimum tax.
The AMT can be triggered in a number of different ways. Although those with higher incomes are more susceptible to the tax, many other factors such as the amount of exemptions or deductions can also prompt the tax. Even commonplace items such as a deduction for state income tax or interest on a second mortgage can set off the AMT.
Watch for Red Flags
Certain circumstances and tax items are likely to trigger the AMT:
If any of these apply to you, you should complete the AMT worksheet provided with the instructions to Form 1040 or fill out Form 6251, Alternative Minimum Tax & Individuals. Taxpayers who fail to pay an AMT liability are subject to penalties and interest.
AMT rates start at 26%, rising to 28% at higher income levels, compared to regular federal tax rates, which start at 10% and step up to 39.6%. Although the AMT rates appear to top out at a lower rate than regular federal income taxes, the AMT calculation allows significantly fewer deductions, making for a potentially larger tax bite.
Unlike regular taxes, the AMT does not allow personal or dependent exemptions or the standard deduction. Moreover, there are no deductions for state and local tax, property tax and a number of other itemized deductions. For example, home-equity loan interest is not deductible if the loan proceeds are not used for home improvements. Accordingly, the more exemptions and deductions claimed, the more likely it is that an AMT liability will apply.
On the positive side, there is a special AMT exemption of $80,800 for joint filers and $51,900 for singles as of 2013; this is designed to prevent the AMT from applying to those with modest incomes. This exemption is reduced by 25 cents for each dollar of AMT taxable income above $115,400 for singles ($153,900 for couples). There's also an 'AMT credit' in future years for some of the extra taxes paid under the AMT. However, this can only be used in a year when the AMT is not paid.
Avoiding the AMT
To avoid or minimize the impact of the AMT, consider these suggestions:
Time capital gains. You may be able to delay an asset sale until after the end of the year, or spread a gain over a number of years by using an installment sale. If you're looking to liquidate an investment with a long-term gain, review the AMT consequences with a tax professional to determine what impact such a sale might have.
Time deductible expenses. When possible, time payments of state and local taxes, home-equity loan interest (if you don't intend to use the loan proceeds for home improvements) and other miscellaneous itemized deductions to fall in years when you won't face the AMT. Since they are not deductible for AMT purposes, they will go unused in a year when the AMT is paid. The same holds true for medical deductions, which face stricter deduction rules for the AMT.
Look before exercising. Exercising incentive stock options is probably the biggest red flag for triggering the AMT. Because the tax issues are complex and the AMT on option proceeds can be significant, you should consult with a qualified tax professional before exercising them.
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