Fiscal cliff negotiations are unlikely to permanently eliminate the alternative minimum tax (AMT). The cost of a permanent fix is too great without substantial spending cuts. The tax code will need to completely redesigned before a permanent fix is proposed. You need to understand the AMT and how it can affect you because sooner or later, you will be touched by it.
The AMT was originally designed by Congress in 1969 to ensure that wealthy individuals could not avoid income tax by exploiting loopholes in the tax code. Unfortunately, the AMT rules were not indexed for inflation. Over the past 40+ years, inflation has caused wage levels to increase significantly, yet the income threshold above which individuals must figure their AMT liability remained unchanged.
President Obama signed Tax Relief Act of 2010 on December 17, 2010, which increased the AMT exemption amounts for tax years 2010 and 2011. However, unless Congress acts to make those increases permanent, AMT exemption amounts will revert back to levels that were in place in 2000.
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That means even more income will be subject to the AMT this year. Fortunately, there are strategies you can use to reduce the likelihood you’ll have to pay the AMT once you understand how it works.
The AMT is a separate, parallel federal income tax system, with two marginal tax rates, 26% and 28%, and different exemption amounts. Under AMT rules, certain exclusions, exemptions, deductions, and credits that would reduce your regular taxable income are not allowed. You must “adjust” your regular taxable income and subtract your AMT exemption amount. If your AMT liability is greater than your regular tax liability, you must pay both your regular tax and the difference. A higher level of income does not necessarily cause you to owe the AMT. It is the relationship between your income and various trigger items that determine your AMT liability. Managing this relationship is the key to avoiding a costly surprise at tax time.
Any number of items may trigger the tax, but large capital gains, personal exemptions, and deductions are the worst culprits. Below is a list of the most common items that may affect your taxable income for AMT purposes, and your potential AMT liability.
- Exercising incentive stock options is typically a triggering item because under AMT rules, you have to recognize as income the “spread” between the market price and the exercise price of your options.
- Personal exemptions are not allowed under AMT rules. Each exemption ($3,800 in 2012) you claim on Form 1040 for yourself, your spouse, and your dependents represent taxable income for AMT purposes.
- The standard deduction is not allowed under AMT rules. Without the benefit of this deduction (in 2012, $11,900 for joint filers; $5,950 for singles), your AMT is higher.
- If you claim a large number of miscellaneous deductions and they total more than 2% of your adjusted gross income (AGI), you may end up owing the AMT.
- Deductions for state and local taxes, including property tax and state income tax, are not allowed under AMT rules. People who live in high-tax states are especially vulnerable.
- Certain credits are not allowed under AMT rules. The more credits you claim on your regular tax form, the more likely it is that you’ll qualify for AMT status.
The AMT was designed to target wealthy taxpayers. The following items are found more often on their tax returns and can generate substantial tax revenues. Under AMT rules, they are not afforded the favored tax treatment they receive under the regular tax rules.
- Tax-exempt income from most “private activity” municipal bonds is taxable under AMT rules.
- Long-term capital gains may exceed the AMT exemption amount. In addition, under AMT rules, there are fewer deductions to offset a large gain.
- Although most tax shelters were eliminated in the Tax Reform Act of 1986, certain shelters still exist, such as oil and gas drilling or other types of limited partnerships. Investing in such a tax shelter may increase the chances of paying AMT.
Managing the relationship between your regular taxable income and the deductions is the key to avoiding or reducing AMT liability. You can manage this relationship by accelerating your income and delaying certain deductions. Working with a qualified tax or financial adviser throughout the year, rather than just at tax time, will help you achieve the best results.
- Municipal bonds – Invest in tax-exempt bonds that are not private activity bonds, or convert some of your AMT bond holdings to non-AMT bond holdings. There are municipal bond mutual funds that specifically avoid AMT exposure. You might even be better off investing in higher yielding taxable bonds.
- Accelerate income – Consider accelerating income in order to report higher regular income relative to your deductions. Receiving more income may result in a lower marginal minimum tax rate of 26% on the first $175,000 of AMT and 28% on amounts in excess of that threshold, versus the maximum 35% federal ordinary income tax rate.
- Defer deductions – The tax-saving advantage of certain deductions will be lost if claimed in a year when you will owe the AMT. Plan the timing of your deductible expenses, particularly tax and medical payments, to achieve fewer deductions relative to your regular taxable income.
- Stock options – The decision to exercise incentive stock options should be made with the help of a qualified financial adviser. If exercising the options would result in you owing the AMT, you could wait until a year when the tax ramifications are more favorable.
- AMT is triggered by the relationship of your income and your deductions.
- Some municipal bonds are subject to AMT. Be careful to select municipal bonds that avoid AMT.
- Consider delaying the sale of a highly appreciated asset until a year when your AMT exposure will be lower.