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Alternative Minimum Tax 101: The AMT Tax Explained

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Alternative Minimum Tax 101: The AMT Tax ExplainedIn 1969, over 150 wealthy individuals avoided paying any U.S. federal income taxes through the use of deductions and other legal tax breaks.  In an attempt to ensure that the affluent pay at least some tax, Congress instituted the alternative minimum tax, also commonly referred to as the AMT tax.

An AMT exemption was also implemented in order to protect middle class taxpayer from the AMT tax.  However, over time, more and more middle class taxpayers were caught in the AMT tax net.  Wages rose with inflation over the years but the alternative minimum tax exemption was never indexed for inflation (at least not until the “fiscal cliff” legislation was passed).

Late in December each year, Congress would meet and pass an AMT tax exemption patch in order to prevent millions of more Americans from being subject to the AMT tax, but wages generally grew faster than these patches.

To give you an indication of how important the patch was, if there had been no patch in 2012, the number of taxpayers subject to alternative minimum tax would have likely increased from about 5 million to about 30 million.

As part of the “fiscal cliff” legislation, the AMT tax exemption was made permanent and will finally be automatically indexed for inflation from the 2012 levels.  The exemption is phased out for higher income taxpayers.

What is the AMT Tax?

The alternative minimum tax is computed under a separate set of tax rules than the regular income tax.  Individuals basically pay the greater of the two taxes.

Under the AMT tax rules, certain income and expenses are recognized under different rules than regular tax, and certain deductions that are allowed for regular tax are limited or not allowed at all for alternative minimum tax purposes.

Common differences under the AMT rules include the following:

  • Standard deductions and personal exemptions are not allowed.
  • Private activity bond interest is taxable
  • The interest on a home equity loan is deductible only to the extent used to acquire or improve the residence.
  • Miscellaneous itemized deductions are not deductible
  • Taxes paid (i.e. state income taxes, property taxes, etc) are not deductible.

The appropriate alternative minimum tax exemption is then subtracted and the difference is then multiplied by the appropriate AMT tax rate to arrive at the tentative minimum tax.  Under the AMT tax rules, income is taxed at 26% up to a certain threshold, and any remaining income is taxed at 28%.  Long term capital gains and qualified dividends are taxed under the same preferential rates for the alternative minimum tax as they are for regular tax.

Regular income tax is then subtracted from the tentative minimum tax to arrive at AMT.  If the tax computed under the AMT tax rules is greater than the tax computed under the regular tax rules, the difference is added to the regular income tax.

Common Causes of the AMT Tax

Taxpayers can be subject to the alternative minimum tax for a number of reasons.  Some of the most common reasons why people are subject to the AMT tax include the following:

  • They live in a state with high income or property taxes
  • They have high capital gains
  • Incentive stock options
  • High miscellaneous itemized deductions

The Minimum Tax Credit

Fortunately there may be some relief available in the form of an AMT  tax credit called the minimum tax credit.

Some alternative minimum tax differences are caused by timing differences whereas other differences between the AMT tax and the regular tax are caused by permanent differences.

The minimum tax credit is available to taxpayers who paid alternative minimum tax generated by deferral items, as opposed to permanent items, in a prior year.

Alternative Minimum Tax Planning Strategies

Congress was successful in making it difficult to get around the alternative minimum tax.  It is not always an easy thing to avoid.

It is crucial to consider the AMT tax when doing tax planning since some strategies that may reduce regular taxes may instead trigger the alternative minimum tax and make the strategy ineffective.

Alternative minimum tax planning strategies may be different than regular tax strategies.  For example, tax planning strategies to reduce regular tax oftentimes include deferring income and accelerating deductions.  The opposite may be true when planning for the alternative minimum tax.

Some common AMT tax planning strategies include the following:

  • Postponing the exercise of incentive stock options.
  • Prepaying real property and state income taxes in December if the taxpayer won’t be in AMT or paying them in January if the taxpayer will be subject to the alternative minimum tax.
  • Accelerating income and reducing deductions.
  • Purchasing AMT free mutual funds if the taxpayer will be subject to the alternative minimum tax or purchasing private activity bonds if the taxpayer won’t be subject to the AMT tax (since the after tax yields are generally higher).

For additional ways to potentially lower your tax liability, consider bunching your deductions and other tax planning strategies.

What are your thoughts about the alternative minimum tax?  Have you ever had to pay the AMT tax?  What strategies have you used to avoid paying it?  Leave a comment below!

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