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How to Reduce Taxes by Passing Up Some Deductions

Last update on: Aug 12 2019
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In early October, Congress voted to extend for another year the higher exemption amounts for the AMT that were enacted in the 2003 tax law. The exemptions were to expire at the end of 2004. Yet, many of you still are likely to be snared by the AMT. You need to carefully review your finances now and consider taking action before Dec. 31 to avoid the AMT.

The AMT is a separate almost-flat tax system. The AMT was designed to ensure that people with very high incomes pay some income taxes.  Because the AMT exemption amount was not indexed for inflation and regular income tax rates were reduced, many non-wealthy are paying the AMT and more will in the future.

To compute the AMT, start with taxable income under the regular income tax, then add back various tax breaks, known as tax preference items. Items that must be added back include personal and dependent deductions, the standard deduction, state and local taxes, foreign taxes, interest on home equity loans when the proceeds are not used to purchase or renovate a home, miscellaneous deductions (such as investment planning and tax preparation fees), and even some medical and dental deductions. These additions result in your alternative minimum taxable income.

Retirees are especially at risk for the AMT. They tend to have more income taxed at the 15% rate for long-term capital gains and for dividends. In addition, charitable contribution and state and local tax deductions tend to be a higher percentage of income for retirees. These factors decrease the regular income tax and could trigger the AMT.

When the AMT is triggered, the benefit of the tax preference items is lost. Charitable contributions and some other deductions still are allowed under the AMT. But the top AMT rate is only 28% versus the top regular rate of 35%. That means there is less tax benefit from the deductions under the AMT, making the after-tax cost higher under the AMT.

Dividends and long-term capital gains are supposed to be taxed at a maximum 15% rate, and at a 5% rate in lower tax brackets. But retirees with a lot of this tax-advantaged income can trigger the AMT and effectively pay a 28% rate on that income.

More details of the AMT and how to avoid it are in the Tax Watch section of the Archive on the members’ web site at www.RetirementWatch.com. Let’s look at some unusual moves to consider if you might be trapped by the AMT this year.

For most taxpayers, it is a simple decision whether to itemize deductions or take the standard deduction. If itemized deductions (mortgage interest, charitable contributions, state and local taxes, miscellaneous itemized expenses, and medical expenses) exceed the standard deduction amount, then itemize deductions. But it doesn’t work that way if you are subject to the AMT.

The standard deduction is not allowed under the AMT. But some itemized expenses are allowed under the AMT, such as mortgage interest (other than most home equity mortgage interest) and charitable contributions. If most of your itemized deductions are allowed under the AMT and you will be subject to the AMT, it makes sense to itemize deductions even when they are less than the standard amount. You will get to take more of the deductions and reduce the AMT.

Even this strategy has tricks. You can elect to itemize deductions even when the standard deduction is higher than your total deductions. The IRS says to write on the dotted line next to line 37 of Form 1040 “IE” (for itemized elected). But the IRS might not notice this when its computers check your return. You might receive a notice from the IRS that additional taxes are due. You then would have to write a letter explaining that you itemized deductions though the standard deduction is higher.

Another trick is that you probably cannot omit deductions to which you are entitled. The issue doesn’t come up much, so there is not much law. For example, you might pay high state and local taxes. These are itemized deductions that are not allowed under the AMT. You might be tempted not to deduct all of them in order to avoid the AMT and to fully benefit from your charitable contribution deductions. If the IRS computers do their job, they will get the amounts from information returns and add the deductions to your income tax return.

But there are other deductions that involve judgment and of which the IRS would not be aware except in an audit. Miscellaneous itemized expenses, for example, often depend on subjective factors such as whether an expense was primarily for investment or business purposes. You might decide to be conservative and conclude that you aren’t eligible to deduct some of these expenses.

Ideally, taxpayers estimate two years of taxes at the same time. If you aren’t subject to the AMT this year but might be next year, it makes sense to accelerate tax preference deductions into this year. For example, you might be able to accelerate some tax payments or miscellaneous itemized expenses. If you might pay the AMT this year but not next, try to accelerate some income into this year. It will face a maximum AMT rate of 28% instead of the regular rate of 35%.

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