Beware of legislators bearing good news.
President Bush's $1.3 trillion tax-relief package announced last year and tweaked a few months ago offers far more to corporate taxpayers than to individuals -- but you knew that already.
The surprising bad news, though, is that the breaks it does offer to individuals likely will push some 36 million people into the Alternative Minimum Tax (AMT) zone -- eradicating any benefit whatsoever.
You're probably familiar with the idea of the AMT. It originally was designed as a separate tax calculation in 1969 to ensure that the super-wealthy paid their fair share of tax and weren't able to deduct away their entire tax liability through various shelters and tax breaks. The goal was to ensure that wealthy taxpayers paid an effective, or average, tax rate comparable to their middle-class counterparts.
But tax breaks aren't just for the super-wealthy any more, and that's the good news. The bad news is that because the AMT hasn't undergone its badly needed overhaul, more and more taxpayers are finding that they owe this alternative tax.
Currently, less than 5 million taxpayers have to pay the AMT, but thanks in part to Bush's tax package -- which failed to address the increasingly unwieldy AMT calculation, as did former President Clinton's 1997 tax relief act -- some 36 million people will pay the AMT by 2010, according to Congress' Joint Committee on Taxation.
Who Gets Snagged?
Unfortunately, there's no specific trigger or test that indicates whether you'll owe the AMT. The alternative tax is figured apart from the regular tax bill, and tends to snag taxpayers who receive a large proportion of their income from long-term capital gains, report large itemized deductions or exercise incentive stock options (ISOs), all of which lower your overall tax rate. If you're entitled to these breaks, by all means, take them. But if any one of them provides a significant benefit and your income is more than $50,000, you should work through Form 6251, on which the AMT is figured. Alternatively, tax-software programs can help with this.
The AMT calculation disallows these so-called preference items, and makes you add them back into your income and pay the separate AMT rate.
Think of it as the reverse of how you typically determine your tax liability. Instead of starting with gross income and subtracting to arrive at taxable income (the way you do on a 1040 form), you essentially start with taxable income and add back the AMT "adjustments" (such as some itemized deductions, including some mortgage interest, medical expenses and state taxes) and preference items (such as the difference between the strike price and the fair market value of incentive stock options when they're exercised).
Deductible charitable contributions, casualty and theft losses, and investment interest do not have to be added back. The result is the Alternative Minimum Taxable Income (AMTI).
Instead of a multitude of little deductions, the AMT calculation provides a more sweeping standard deduction of $49,000 for married couples filing jointly and $35,750 for single filers, although that exemption phases out at $346,000 on a joint return and $255,500 on a single. Remaining income of $175,000 or less is taxed at 26%; any income exceeding that is taxed at 28%.
These numbers were modestly adjusted under the new tax package -- the prior standard deduction for married couples had been $45,000 and for singles, $33,750. Such a marginal increase, though, does little (if any) good. In fact, the congressional Joint Committee on Taxation determined that half of the projected increase in taxpayers ensnared by the AMT is attributed to the fact that the AMT standard deduction hasn't been adjusted for inflation. The other 18 million will be trapped by the AMT as a direct result of the Tax Relief Act of 2001.
Unfortunately, the only way to strategize is to calculate several possible tax scenarios in the coming months. If you think you may run into the AMT, talk to a tax adviser -- and the sooner the better.
If you can't avoid the AMT, though, there may be a few ways to make it work for you. For example, if exercising incentive stock options would push you into the AMT for 2002, it might be wise to wait until January before reaping any long-term capital gains, which would be taxed at the AMT rate of 28% if taken this year, instead of the standard 20% rate. (Then again, tax planning should be a part of your investing decisions -- but not dictate them. So don't wait to sell purely for tax reasons.)
It may pay to accelerate some ordinary income into 2002, however, if you're already sure you'll encounter the AMT. That way, income that normally would be taxed at your regular rate -- as much as 38.6% -- will only be subject to the 26% or 28% AMT rate.
For instance, if your employer allows you to choose whether to accept your holiday bonus in December or January, conventional wisdom dictates deferring the extra income by a few days or weeks in order to postpone paying tax on it by a year. But if you incur the AMT this year, but might not in the next, it might pay to take that bonus check in December. If you already know you're paying the AMT for 2002, you also know that your overall income (including that bonus) will be taxed at a maximum rate of 28%.