The Alternative Minimum Tax Trap and How to Avoid It
The alternative minimum tax (AMT) was established in 1969 to ensure that every taxpayer, particularly wealthy individuals and corporations, pay at least some income tax each year. In 1970, the first year the AMT system went into effect, it ensnared 155 high-income households.
Today, it's estimated that at least 4 million households will be forced to pay the higher tax -- a 25,805% increase in AMT payers since 1970 versus a 52% increase in the population of the U.S. It's also estimated that up to 39% of married couples with children will qualify for the AMT.
The number of AMT payers is increasing not because people are making more money in real dollars, but because the AMT threshold has not been adjusted effectively enough for inflation. Congress adjusts the regular tax brackets and personal exemptions each year to account for inflation and prevent "bracket creep," which is the tendency for people to be shifted upward through marginal income tax brackets due to inflation. Unfortunately, it has failed to do the same for the AMT.
Congress has approved temporary patches over the past few years to increase the amount of income that is exempt from the AMT. Unfortunately, these adjustments are designed to keep new people from being ensnared, not to help those who already are.
How Do I Know If I Qualify?
The AMT rules don't allow qualifying taxpayers to take many of the exemptions and deductions that can be used to shelter income from taxes. So knowing whether you’re a potential AMT victim could be important when deciding on some of your usual year-end tax moves. Unfortunately, there's no easy way to know if you will be subject to the AMT. If you qualified last year and your circumstances haven't changed much, you'll probably qualify again this year.
The AMT system is notoriously complicated. If you have a large number of itemized deductions, a lot of children or dependents, a large number of incentive stock options, or if you pay high state taxes, local taxes or personal property taxes, there's a high probability that you'll qualify for the AMT.
The IRS has set up an Alternative Minimum Tax Assistant for individuals on their web site at www.irs.gov. The assistant will lead you through a simple test to see if you are subject to the AMT. Click here to see if you qualify.
What If I Do Qualify for AMT?
If you qualify, you have to calculate the AMT separately from the "regular" taxes calculated on your IRS Form 1040. Using IRS Form 6251, start with taxable income (income after personal exemptions and standard or itemized deductions) and add back the various adjustments (the AMT instructions at IRS.gov will lead you through this) to arrive at the net alternative taxable income.
Once the disallowed exemptions are backed-out, the resulting higher taxable income is taxed at flat rate. The taxpayer compares the AMT tax to the tax calucated under the "regular" method and owes the higher of the two.
The exemption amounts for figuring the AMT change each year, so it's important to refer to the IRS instructions or a tax professional.
What Can I Do To Avoid the AMT?
The goal of the AMT is to make sure that everyone pays at least some income tax, and Congress did a pretty good job of ensuring that you can't circumvent it.
That being said, the AMT is a good example of why taxpayers should take time to plan for taxes and consult a tax professional. In some cases, people who qualify for the AMT may be able to lower their tax bill by making certain changes, such as establishing a qualifying home office or only using home equity lines of credit to improve the home.
As mentioned earlier, the exemption amounts for figuring the AMT change each year, so it's important to refer to the IRS instructions or a tax professional for the latest information.
Personalized Financial Plans for an Uncertain Market
In today’s uncertain market, investors are looking for answers to help them grow and protect their savings. So we partnered with Vanguard Advisers -- one of the most trusted names in finance -- to offer you a financial plan built to withstand a variety of market and economic conditions. A Vanguard advisor will craft your customized plan and then manage your savings, giving you more confidence to help you meet your goals. Click here to get started.