Understanding The AMT
With the tax deadline upon us, I wanted to highlight a tax that is affecting more American taxpayers than ever before. The Alternative Minimum Tax (AMT), originally meant to impact only the wealthiest of individuals, has become a burden for a growing number of taxpayers each year. In 1970 roughly 20,000 taxpayers paid the AMT. However, as of 2011, that number grew to more than 4 million. This was due to the fact that the income levels associated with AMT were not tied to an inflation adjustment scheme. In this article, we will explain the nature of the AMT, its impact, strategies to minimize it, and the recent changes.
What is AMT?
The Alternative Minimum Tax is a separate federal tax system. It was introduced in 1969 to ensure that individuals with the highest incomes, who were taking advantage of a large number of available deductions to reduce their tax liability, pay at least a minimum amount of tax. The AMT has its own rules, forms, rates and adjustments. A general suggestion is that every individual with an annual income of $100,000 and higher should determine if there is any alternative minimum tax liability.
Who is vulnerable to the Alternative Minimum Tax?
Originally the AMT was created to make people with very high incomes pay their taxes, in the recent years it has hit significantly more upper-middle income taxpayers (4 million people in 2011). This is because the AMT exemptions were not indexed for inflation for many years, while wages were growing significantly. As a result, the number of people paying AMT has increased considerably. According to the Urban-Brooking Tax Policy Center, taxpayers with the annual income between $200,000 and $500,000 have a 48% chance to pay AMT. Why is it so? It happens because taxpayers with the highest income pay regular tax rate higher than the top AMT rates (26% and 28%), while middle-class individuals have to pay the additional tax. Also, you may have to owe the AMT if you take large itemized deductions, exercise stock options, or live in the state with high state income taxes.
How much revenue does the AMT raise?
When introduced in 1970, the alternative minimum tax generated $122 million (approximately $700 million in today's dollars). This number rapidly grew to $6.7 billion in 1986 and $39 billion in 2011. If the American Taxpayer Relief Act of 2012 was not passed, the AMT revenue was expected to increase to $131 billion in 2013 and to $398 billion after 10 years, in 2022. (Source: Urban-Bookings Tax policy Center)
What is new about the AMT?
As stated above, AMT exemptions were not increasing with inflation making more individuals be subject to this tax. Therefore, for the last 44 years the AMT has been increasingly affecting taxpayers. However, there is a hope that the AMT impact on the middle-income taxpayers will be reduced due to the American Taxpayer Relief Act of 2012. The American Taxpayer Relief Act of 2012 has created a permanent annual patch which means that AMT exemptions will be indexed for inflation going forward. Thus, less income will be subject to the AMT in the coming years. The AMT exemptions are:
Single filers $50,600
Married Filing Jointly $78,750
Married Filing Separately $39,375
Head of Household $50,600
Kiddie tax exemption is the lesser of the AMT exemption for a single taxpayer or the child's earned income plus $6,950
If this change had not been made, more than 30 million taxpayers would have been affected by the AMT this year!
How do you know if you owe Alternative Minimum Tax liability?
AMT Calculation Summary:
1. Calculate Adjusted Gross Income (Form 1040, line 38)
2. Add/subtract adjustments/preferences to compute Alternative Minimum Taxable income
3. Subtract AMT exemption to figure Alternative Minimum Tax Base
4. Multiply this amount by AMT Tax Rate (26% or 28%) to calculate Tentative AMT
5. Subtract any AMT Foreign Tax Credit (depending on the income threshold) to calculate your Alternative Minimum Tax liability
6. Pay the greater of regular income tax or AMT
To calculate the alternative minimum tax, you need to use IRS Form 6251. Under the AMT system, you cannot take certain adjustments and deductions including state, local, real estate, and personal property taxes (itemized and reported on Schedule A), home mortgage interest adjustments (unless the proceeds were used to buy, build, or improve your home), miscellaneous deductions from Schedule A subject to the 2% of AGI limitation and others. One of the largest income triggers for the AMT liability is the exercise of incentive stock. When an option is exercised, there is no tax due under the regular tax system.
However, the difference between the option price and the market value on the date of the exercise must be reported for the AMT purposes. Also, the AMT does not have personal exemptions which you can deduct when computing your regular tax. That means that the larger family you have, the less beneficial it is for you for the AMT purposes. For example, a family with four children qualifies for $15,200 in deductions under the regular income tax system, whereas those deductions are disallowed under the alternative minimum tax. Once you have calculated your AMT liability, compare it with your regular income tax and pay whichever is higher.
If you do not realize that you may owe the AMT and you do not file by the deadline, you can be liable to pay the AMT and penalties calculated by the Internal Revenue Services (IRS).
How might someone reduce his AMT liability?
There are strategies that you may utilize to decrease your AMT tax. Some of them are listed below.
● Participating in a cafeteria plans if offered by your employer – it will allows you to reduce your income by paying medical, dental, and life insurance premiums on a pre-tax basis.
● Participating in retirement plans including 401(k), 403(b), SARSEP, 457 or SIMPLE plans making pre-tax contributions
● Selling incentive based stock options in the year you exercise them or spreading the sale over the years
● Using home equity loan proceeds only to buy, build, or improve your home
● Avoid prepaying state and local income or property taxes
● Claiming your business expenses on Schedule C instead of on Schedule A (if you are a business owner)
● Making charitable contributions to reduce your adjusted gross income
● Taking advantage of Alternative Minimum Tax credit which can reduce your tax liability to the extent of the amount by which your regular income tax exceeds AMT.
Also, you can carry forward your unused credit indefinitely to the future years. Form 8801 'Credit for Prior Year Minimum Tax – Individuals, Estates, and Trusts" is used to calculate a credit.
AMT is a complex tax system. Although the AMT tax rates are lower than those of the regular income tax, the AMT liability can be higher due to significantly fewer deductions allowed under the AMT system. As every individual's circumstances are unique, you need to conduct advance proper tax planning which may help you reduce the impact of AMT. You can check if you possibly have to pay the AMT by using an online AMT Assistant calculator provided by the Internal Revenue Service (IRS).
This article is just an introduction to the Alternative Minimum Tax matter. If you have questions about the AMT and Form 6251, contact your tax professional or if you would like additional information, I can be reached at email@example.com. Elena holds a Masters Degree in Financial Planning and heads the Financial Planning Department of Streettalk Advisors, LLC.