Q: You mentioned the AMT in passing, but I was wondering if you could do a post on it. My wife and I have never been subject to the AMT, but the time is coming when we probably will be. Could you please explain the AMT, including what makes one susceptible to it? And also talk about ways to avoid it?
A: Bill, the alternative minimum tax (or "AMT") is designed to disallow tax deductions for higher-income taxpayers. The goal is to make sure that people that have the means to do so pay at least some income tax. However, the AMT has turned out to be nothing more than a stealth tax on the almost-rich.
For more on the AMT, consult the IRS Instructions for Form 6251, which is where the AMT is calculated.
What Is the AMT, and Who Does It Affect?
The AMT began in the late 1960s, when the Treasury Secretary told a Congressional committee that a couple of hundred wealthy taxpayers had used deductions in the code to avoid paying income tax altogether. The story goes that Congress received more hate mail on this issue that year than on the Vietnam War.
Congress installed an AMT, and modified it over the years. Its current form was put in place as part of the Tax Reform Act of 1986. Tax wonks will remember that the top marginal tax rate from that bill was 28%. The AMT has a top marginal tax rate of 20%. Therefore, the idea was to make sure high-income taxpayers paid at pretty close to the top marginal tax rates, despite their deductions.
Then the tax increases came. In 1990 and 1993, the top marginal income tax rate went to 31%, then 39.6%. As a result, wealthy taxpayers were paying higher taxes using the normal rules than they were using the AMT rules (which had lower rates and less deductions--the AMT top rate rose to 26% in 1990 and 28% in 1993). Low- and moderate-income people were exempted from the AMT. That left the upper-middle class.
And that's where it stands today. Low- and moderate-income taxpayers are shielded from the AMT because of the AMT "standard deduction." High income taxpayers don't need to bother calculating the AMT because the regular system soaks them thoroughly. It's the upper middle class that pay the AMT.
Calculating the AMT
So how does it work? First, you calculate your taxes as normal. You add up your income and subtract off your adjustments to get to adjusted gross income. You then take either the standard deduction, or your several itemized deductions. You subtract off any exemptions you are allowed. This calculates your tax.
If you're in the AMT danger zone (not a precise range, but something like $100,000-$300,000 in AGI), you then have to calculate your AMT tax burden.
This is done by taking your AGI and taking a new, restricted set of deductions. These deductions are:
- Medical expenses that exceed 10% of AGI. The normal deduction allows for a 7.5% of AGI floor.
- Home mortgage interest on "acquisition debt," subject to the 2 home/$1,000,000 mortgage limit. Interest from home equity debt is not allowed.
- State tax refund you reported as income. This helps, since it takes income away from the AMT. The reason? You are not allowed a deduction for state income tax paid, so the refund isn't taxed, either.
- Depreciation deductions on business and rental income. These are done using slower depreciable lives. For instance, structures are 40 years, furniture is 10 years, and technical equipment is 7 years.
- Charitable contributions.
This gives you AMT taxable income. This disallows a lot of deductions that you are allowed under the normal tax rules (the biggest ones being the deduction for state and local taxes, home equity loan interest, miscellaneous itemized deductions, tax-free incentive stock option exercises, casualty and theft losses, and accelerated depreciation).
You are then allowed an AMT exemption. For 2007, the exemption is $44,350 if single (phases out after $112,500 of AMT taxable income); $66,250 if married filing jointly (phases out after $150,000 of AMT taxable income); $33,125 if married filing separately (phases out after $75,000 of AMT taxable income).
You then take the resulting amount and multiply it by the AMT tax brackets:
$0-$175,000 ($0-$87,500 MFS): 26%
$175,001- ($87,501- MFS): 28%
You then have two numbers: your regular tax calculated (done at the beginning of this effort), and your AMT tax liability.
You pay whatever is higher.
The exemption amount is routinely indexed to inflation every year by Congress. Nonetheless, millions of upper-middle class taxpayers fall into the AMT every year.
Avoiding the AMT
How can you tell if you are a candidate to be zinged by the AMT? Here are some common characteristics of AMT taxpayers:
- You are married
- You have children
- Your household income is in the six figures, but not more than $300,000.
- You have a big mortgage on your house
- You live in a high-tax state (usually Gore-Kerry voting "blue" states)
The more of those descriptions that apply to you, the more likely you are to be an AMT taxpayer.
What are some good strategies for avoiding AMT?
- Max out your 401(k) at work. You can put in up to $15,500 in your 401(k) in 2008 ($20,500 if you are over 50). This reduces your wages, which reduces your AGI.
- If your wife doesn't work and you make less than $159,000-$169,000, have her make a Traditional IRA deduction. She can contribute up to $4000 this year ($5000 if she is over 50).
- Take advantage of any other workplace fringe benefits that can reduce income. These include health savings account (HSA) contributions, pre-tax commuting benefits, etc.
- Avoid the temptation to cash out the equity in your home. The interest probably won't be deductible, so paying 8% interest is probably not worth it. If you have outstanding home equity debt, pay it off.
- Make sure you get reimbursed by your employer for business expenses. You won't be able to claim them as an itemized deduction.
- Pay for your medical expenses using a flexible savings account (FSA) offered by your employer, or an HSA if you are eligible. This avoids the need to claim a medical expense deduction which may be disallowed.
- Move. I'm serious. This has two advantages. First, you can claim a moving expense adjustment. Second, moving to a lower-tax state means that if the deduction for state and local taxes is disallowed, it won't have as big of an impact.
Most of all, I implore anyone who is in AMT to hire a tax professional. It's worth the effort.