The alternative minimum tax (AMT) is a great example of how legislation passed in Washington, D.C. can backfire on the general public.
The AMT is best described as a parallel tax category created by Congress to operate alongside the traditional federal income tax.
The AMT calls for certain taxpayers to calculate their tax liability two times - first under the regulations laid out for regular income taxes and a second time to comply with AMT rules and mandates. The AMT expands the amount of income that can be taxed by the federal government.
It does so by recalculating an individual's income tax after adding certain deductions into the taxpayer's adjusted gross income. The deductions are included in the taxpayer's annual income to figure out that individual's alternative minimum taxable income. After that, the AMT exemption is subtracted to reach the individual's tax obligations to Uncle Sam.
Primarily, the alternative minimum tax impacts higher-income Americans who have between $200,000 to $1 million in annual income. Still, U.S. taxpayers who earn as little as $75,000 can be ensnared in the AMT, based on IRS qualification rules.
Focus on IRS Form 6251
Taxpayers wondering if they're subject to the AMT need to complete IRS Form 6251.
If the calculated tax on IRS Form 6251 exceeds the tax obligation listed on the regular IRS tax form, you'll need to pay the difference, as well as paying any tax owed based on your regular IRS tax form. The taxes owed can really add up, as the AMT requires taxpayers to include tax-saving items back into their income, including:
- The individual's standard deduction.
- The deduction for state and local taxes.
- Any personal exemptions.
- Home equity mortgage interest.
- Employee business expenses and other miscellaneous deductions.
- Medical expenses.
The alternative minimum tax also kicks in after adding income earned that's not included in the regular income tax, including:
- Fair market value of certain stock options exercised but not sold.
- Tax-exempt interest from private activity bonds.
- Foreign tax credits.
- Passive income and losses.
- Net operating loss deductions.
The Origins of the Alternative Minimum Tax
How did a tax law created by Congress designed to protect the middle-class wind up dragging more Main Street taxpayers into a higher tax burden?
It's complicated, but the Alternative Minimum Tax has a long, slightly twisted history since it was first rolled out in 1969 (known then as the "millionaire's tax.)
Here's the background. In 1969, 155 wealthier Americans used so many tax breaks, deductions, and other strategies, that each wound up paying no federal income tax. Congress caught wind of the gambit, and eventually instituted a parallel shadow tax to the U.S. tax code, that was designed to eliminate the type of tax-avoiding strategies deployed by a few high-income Americans.
Thus, the alternative minimum tax was born, and with it, a track record of legislative futility, as more and more middle-class Americans were ensnared in the AMT due to a major accounting omission - unlike traditional income taxes, the AMT wasn't indexed to inflation when the bill was passed by Congress.
Eventually, the omission was fixed and the AMT was indexed to inflation, but that didn't occur until 2013, when President Barack Obama signed off on the American Taxpayer Relief Act of 2012. That was way too late for the 5.2 million middle-class Americans subjected to the alternative minimum tax - up from 200,000 in 1982.
Another key piece of tax legislation - the Tax Cut and Jobs Act of 2017 - included a provision to significantly boost AMT exemption levels and, hopefully, bring the number of Americans subject to the AMT back down to 1982 levels.
Economically, the alternative minimum tax has a minimum impact on the U.S. economy. According to IRS figures, the AMT collects about $38 billion in taxes in 2017, a small drop in the bucket given that Uncle Sam collected $3.4 trillion in federal taxes in 2017.
Alternative Minimum Tax Exemption Levels
Now that the alternative minimum tax adjusts with inflation, exemptions from the AMT are higher than prior to 2013. In 2018, IRS AMT exemption levels are as follows:
- Single taxpayers: $70,300
- Married taxpayers filing jointly: $109,400
- Married filing separately: $54,700
- Head of household: $70,300
Based on the Tax Cut and Jobs Act of 2017, exemptions and phase-out levels will rise from 2018 through 2015, which should curb the number of Americans exposed to the alternative minimum tax. In fact, the U.S. government estimates the number of taxpayers exposed to the AMT will fall from five million to 200,000 during that time frame.
If you wind up having to pay the alternative minimum tax, pay it - there really isn't any practical way to get around it.
What you can do, however, is to take specific steps to avoid paying the AMT the following year.
You can do so by asking your company to reimburse you for any AMT taxes paid, don't prepay your real estate property taxes in the current tax year, and sell any exercised incentive stock options in the same calendar year that you exercised those options. Any exercised stock options that are unsold are deemed as income by the IRS and subjected to the AMT.
How to Plan for the Alternative Minimum Tax
Here are some additional ways to reduce taxes owed on the alternative minimum tax:
- Boost your retirement plan contributions. Any contributions to an employer retirement plan, including a 401(k) plan or a tax-deductible IRA, lowers your gross annual income. That lessens the odds of your qualifying for the AMT.
- Leverage a flexible spending account. Paying medical expenses through a flexible spending account or a health savings account, and funding those plans with pre-tax money, can also reduce your gross annual income, and make you less likely to pay an alternative minimum tax.
- Move to itemized tax deductions. Instead of calculating your taxes using the standard deduction, transition to itemized tax deductions. Certain itemized deductions are allowable under the AMT.
- Cut any taxable investment income. To further reduce your annual income, and boost your chances of avoiding the AMT, lower your tax obligations by making some smart investment moves. For instance, you can harvest investment losses to offset any capital gains earned over the course of the tax year. Big capital gains often push taxpayers into AMT territory, so any way to minimize them can help you bypass the alternative minimum tax.
- Hike your charitable contributions. Boosting your charitable contributions can lower your annual income, and keep you safe from triggering the AMT.