This is the transition year. For many Americans it will be a transition to higher income taxes. Beginning in 2004, millions more Americans will get snared in the alternative minimum tax (AMT). They will pay hundreds or even thousands of dollars more in taxes than they imagined possible. They will lose the benefit of tax breaks they thought were secure.
Retirees will be disproportionately among the AMT’s victims. If you have a fairly high amount of itemized deductions, you are likely to get snared. This means if you pay high state and local income or property taxes, you could be a victim. If you have long-term capital gains or other tax-favored income (such as dividends), the AMT could be in your future. If have a home equity loan or line of credit that was not used to buy or renovate a home, the AMT could be in your future.
Official estimates are that 2.6 million taxpayers will pay the AMT for 2003, and that will jump to 12.3 million by 2005 if no changes are made. The broadening grasp of the AMT is caused by rising state and local taxes, the reduction in regular income tax rates, and the lack of indexing for the AMT exemption.
The AMT was designed to prevent the superwealthy from avoiding all income taxes. The IRS’s Taxpayer Advocate reports, however, that the AMT now affects almost as many people with incomes less than $50,000 as it does those with incomes approaching $500,000. By 2010, 90% of those earning $100,000 to $500,000 will pay the AMT.
I’ve been warning about the AMT for some time. If you have procrastinated, now is the time to take action. You cannot wait until the end of the year or even the last quarter of the year to deal with the AMT. You need to determine now if you might be hit by the AMT and set a plan of action for the rest of the year. You also need to understand that one of the many ghoulish aspects of the AMT is that the steps for avoiding it are counterintuitive to many taxpayers.
The AMT is a parallel, almost-flat tax system. It has its own rules. Each taxpayer computes his or her tax bill under the regular rules and under the AMT. You pay the higher of the two bills. The IRS’s computers automatically compute the AMT for most tax returns, just in case you don’t. That’s how many taxpayers first learn about the AMT. They get a letter from the IRS explaining that it computed the AMT and determined they need to pay its higher amount.
Here’s how the AMT works.
Start with your regular taxable income. Then, add back a number of tax preference items. These 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.
You get to subtract an exemption. This exemption amount was boosted in the recent tax laws to $58,000 on joint returns and $40,250 for individuals. The exemption amount still is far less than it would be if the original exemption amount were indexed for inflation. Then, apply the AMT rate, which essentially is a flat rate of 28%, though lower incomes pay a 26% rate.
Also, under the AMT you lose some tax credits that are allowed under the regular tax. These credits won’t reduce your tax under the AMT.
Perhaps the most insidious trap in the AMT is the phaseout of the exemption amount. When AGI is over $150,000 on a joint return or $112,500 for single taxpayers, the exemption is phased out. It disappears at incomes of $382,000 and $273,500, respectively.
Long-term capital gains are supposed to be taxed at the 15% under the AMT, but you will lose some of the benefit of the lower rate. For example, capital gains under the regular tax aren’t taxed at the 15% rate from the first dollar; under the AMT they are. Also, some deductions that can shelter the gains under the regular tax are lost under the AMT. In addition, a relatively large amount of gains can push you into the AMT or into the phaseout range for the exemption amount.
So, though long-term capital gains technically are not affected by the AMT, these three factors operate to effectively increase taxes on long-term gains for those affected by the AMT.
Charitable contributions are other valuable tax benefits that technically aren’t reduced by the AMT but effectively are diminished by it. You do get to deduct all your charitable contributions under both the regular tax and the AMT. But the maximum rate under the regular tax is 35%. The AMT maximum rate is 28%. That reduces the tax benefit of your contribution.
If you make a $100,000 charitable contribution under the regular tax, you expect it to reduce income taxes by $35,000. But under the AMT, it reduces your taxes by only $28,000.
In addition, when the charitable contribution is made it reduces the regular income tax. Reducing the regular income tax can increase the likelihood of being subject to the AMT, since you pay the higher of the two.
The bottom line of the AMT is that middle income taxpayers need to worry about it. Any taxpayer with income of more than the exemption amount needs to check for vulnerability to the AMT. Keep checking during the year. Any changes in income or deductions during the year could trigger the AMT.
When the AMT is a possibility, two or more tax years should be planned at once. If income and expense streams are reliable, it might be possible to plan more than two years.
There are two basic types of AMT taxpayers. One type is the taxpayer who is subject to the AMT some years, but not every year. The other type is almost certain to be hit with the AMT every year. The appropriate strategies are different for the two types.
When the AMT is not an annual event, income and expenses can be managed to reduce the frequency of the AMT or the damage it does.
One strategy is to defer the AMT preference deductions from one year to the next. For example, some state and local tax payments could be delayed until the following January. Some taxpayers find it is cheaper to incur late payment penalties on those items instead of triggering the AMT. You should consider deferring payment any tax preference deduction.
You also should plan carefully tax benefits that are not tax preference items, such as long-term capital gains and charitable contributions. For example, instead of making a large charitable contribution or taking a capital gain one year it could be spread over several years. Doing so might avoid the AMT each year and ensure maximum tax benefits from the contribution or gain.
Stock options really complicate the AMT picture. If you have stock options, do not exercise them until getting advice from an experienced tax advisor who demonstrates all the tax implications to you. In many cases, it makes sense to exercise the options in installments instead of in one year.
Taxpayers are likely to pay the AMT every year when they live in high tax states or have a lot of long-term capital gains or dividend income. For these taxpayers, the best strategy usually is to try to restructure tax preference items.
For example, mutual fund management expenses are subtracted directly from the fund, reducing gains or increasing losses. But management fees for a separate account are separately stated and are miscellaneous itemized expenses, a tax preference item. You lose their benefit under the AMT. It could be better to move some money out of separate accounts into mutual funds.
Likewise, employment-related expenses are itemized deductions eliminated under the AMT. It would be better to have the employer pay them directly for you, even if that means having gross income adjusted.
The perpetual AMT taxpayer also has to realize that deductions such as charitable contributions will always have a lower benefit at the 28% AMT rate than at the maximum 35% rate for regular taxpayers.
Of course, when doing your planning don’t let the tax code dictate your financial moves. The first priority is to make the right investment and financial moves for you. After that, see if those strategies can be structured to reduce the tax bill.