One Way or Another, the AMT's Going to Getcha, Getcha, Getcha, Getcha
The $1.35 trillion tax-cut package signed into law recently by
President Bush
contains a lot of great-sounding tax breaks -- reductions that the popular press has publicized as being heavily weighted toward the wealthy.
And it's true that the top 1% or so on the income ladder should do very nicely under the new law. They get their marginal tax rate gradually reduced from 39.6% down to 35% in 2006 and later years. But there are also plenty of goodies for those with incomes in the middle to upper, but not stratospheric, range. The 36% bracket drops to 33%, the 31% to 28%, and the 28% to 25%. There's also a new 10% bracket for the very bottom portion of everyone's taxable income.
In the future, the amount of income taxed at 15% will increase for joint filers until it is twice what it is for singles. Plus, the standard deduction will increase for joint filers until it is double that of singles. And those sneaky provisions that now cause upper-income individuals to lose part or all of their personal and dependency exemptions and up to 80% of many of their itemized deductions will also phase out and eventually disappear altogether.
All in all, some pretty nice tax cuts.
But wait -- there's one little problem that will cause a lot of people never to see the tax savings that are now dancing before their eyes. It's the dreaded alternative minimum tax, or AMT. The AMT has been creeping up on more and more people in the past few years, currently hitting about a million or so of them with additional taxes.
If the new tax law hadn't made any adjustments to the AMT, it would have caused the number of taxpayers hit by the AMT to balloon.
Congress
couldn't have that, but didn't have the dollars available to fix the problem. So it came up with a partial fix, and only a temporary one at that. It increased the amount that's exempt from the AMT by a few thousand dollars, but only through 2004.
A Little Background on the AMT
The AMT is a kind of second income tax scheme. It was designed to ensure that high-income folks who were taking all kinds of deductions and credits -- many associated with tax shelters -- wouldn't get away with paying no income tax. So the AMT starts with regular taxable income and adds back a variety of deductions, exemptions and credits that were claimed for regular income tax purposes. Then an "exemption amount" is subtracted --$45,000 for joint return filers, $33,750 for singles or $22,500 for separately filing marrieds. At higher income levels -- for example, above $150,000 for joint filers -- the exemption amounts phase down to zero.
What's left is subject to AMT at a rate of 26% for the first $175,000 ($87,500 for separate-filing marrieds), and 28% on higher amounts.
If your regular income tax is more than your AMT, you pay the regular tax. If the AMT is the higher of the two, you pay that. Not what most of us would call a win-win.
The reason the AMT has been creeping down to hit upper-middle and even some middle income people is that neither the AMT rate brackets nor the exemption amounts are indexed for inflation, while the regular tax rate brackets, personal exemptions, standard deductions and many other allowances are. Indexing reduces regular taxes while the AMT stays the same, making it more likely that one's AMT will be more than the regular tax.
You may be thinking that the AMT still shouldn't hit most of these people, because they don't have tax shelter deductions, but the fact is, a lot more deductions are added back to AMT income than you might think, most of which have nothing to do with tax shelters. All of your personal exemptions and dependency deductions, for example, and deductions for state and local income taxes and property taxes are added back. Some medical deductions and most interest on home equity debt are added back as well.
And even the standard deduction gets thrown back into the pot! Another biggie is the bargain element in incentive stock options (ISO). You owe no regular tax when you exercise an ISO, but the spread between the exercise price and the value at exercise is an AMT preference that gets added back to AMT income.
The Rub
The kicker is that all of those wonderful new tax breaks outlined above apply for regular income tax purposes -- but not for the AMT. What the new law did for the AMT is to raise the exemption amount by $4,000 -- to $49,000 for married couples filing a joint return and surviving spouses, by $2,000 for singles and for married individuals filing separately, to $35,750 and $24,500, respectively. And it only did that for 2001 through 2004.
Without this change, the new tax breaks would have caused many more people to be subject to the AMT, because their regular income tax would drop below the level of their AMT. The temporary fix will keep some people out of this mess -- but only until 2005.
Then, if nothing else is done, there will be political hell to pay when the AMT hits home with unprecedented force. It's been estimated that if the AMT isn't fixed, more than 35 million people will be hit with AMT by the time the new tax changes are fully phased in around 2010. Presumably, the prospect of 35 million unhappy voters will be enough for whatever kind of Congress and administration are in power at that time to alleviate the problem. But it won't be a cheap fix, and it will be hard to do without cutting other spending, especially if there's an economic downturn and projected surpluses don't materialize.
One irony of the tax changes is that it's individuals in the highest income group who will generally get the full benefit of the new law's tax breaks. That's because their regular tax rates are much higher than the AMT rates and they don't get any AMT exemption, so their regular tax is more than their AMT even after adding back all of those deductions that aren't permitted for AMT purposes. And the truth is that most of them don't have a lot of tax shelter deductions to add back in anyway, because of changes to the regular tax rules over the past 15 or so years that have drastically reduced tax shelter activity. So they generally will realize the full benefit of the tax rate reductions and other new breaks.
Others who may not have to worry too much about the AMT are those from low-tax states who don't pay much in the way of state or local income tax or property taxes. They're much less likely than those from the Northeast or the West coast to be hit with the AMT because those taxes aren't added back to their AMT income.
Securities investors can take some comfort in the fact that the AMT rates of 26% and 28% don't apply to long-term capital gains, which normally are taxed at only 20%. However, that's somewhat cold comfort, because those gains are added in with other income, such as wages, bonuses, interest and dividends, to determine if that other income is subject to the AMT and the rate at which it's taxed. So while capital gains aren't hit directly by the AMT, they can cause other income to be subject to it.
James Seidel is a tax attorney and senior manager of news and alerts at RIA, a provider of information and technology for tax professionals.