By Geoffrey M. Zimmerman, CFP
Learn more about Geoffrey on NerdWallet’s Ask an Advisor
Tax season is over, but if you had to pay the federal alternative minimum tax, the pain may linger long after you’ve filed.
The AMT is an alternative method of calculating federal income tax that runs parallel to the ordinary method. To determine whether you are subject to the AMT, you have to map both routes simultaneously. Whichever route results in the greater tax amount, that’s the one you follow — and that’s the amount you pay.
Of course, the AMT is the road no one likes to travel — it’s the higher tax route. To develop appropriate planning strategies, it is important to first understand how AMT works.
Where the road began
In 1969, Congress created the AMT as a tax on the wealthy, with the aim of making sure the highest earners paid their fair share. At the time, the AMT affected just a handful of high earners with annual incomes of more than $200,000. Today, despite tax law changes over the years, the AMT affects more and more people earning upper-middle-class incomes.
The AMT has its own tax rates and set of rules regarding income and expenses. Under the regular tax system, depending on your filing status and how much net income you earn in a year, you fall into one or more of seven tax brackets: 10%, 15%, 25%, 28%, 33%, 35% and 39.6%. AMT rates are more complicated, though there are fewer official marginal tax rates: 0%, 26% and 28%. Due to the AMT exemption, which phases out as income increases, the highest “unofficial” rate is 35%. (More on this below.)
How it works
Under the AMT calculation, you can’t claim many of the regular deductions or the personal exemption you would normally claim. Only the applicable AMT exemption and a few specific deductions are allowed.
Your alternative minimum taxable income, or AMTI, will generally be your adjusted gross income less itemized deductions (your income as seen on line 41 of Form 1040), plus those other deductions added back in. This includes state income taxes, personal property taxes and real estate taxes, home mortgage interest, miscellaneous deductions and other items (see Form 6251 for a complete list). You’ll also need to add in any preferential income, like the bargain element (the difference between the price you pay as an employee and the market price) on the exercise of any incentive stock options. These additions can cause your AMTI to exceed your AGI.
Your AMTI may then be reduced by the applicable AMT exemption. This exemption starts at $83,800 for a married couple filing jointly in 2016, but it is reduced by 25 cents for every $1 of AMTI above $159,700. The exemption is fully phased out when AMTI exceeds $494,500.
Assuming there are no qualified dividends or capital gains, you then calculate the AMT on the result: That’s 26% of the first $186,300, and 28% on amounts above that. These are the official AMT tax brackets. The presence of the phase-out of the AMT exemption creates a window between $186,300 and $494,500 where AMTI is effectively being taxed at a 35% marginal rate. It is critical to know whether you are in this window or above this window to plan effective tax strategies.
An additional wrinkle is created when investors realize long-term capital gains or receive qualified dividends. While the lower maximum tax rates that apply to long-term capital gains are also in effect under the AMT, long-term capital gains and dividends still count as income under the AMT. Significant earnings from those sources could actually push your overall income to the levels where the AMT exemption begins to phase out, causing your non-dividend and non-capital-gain income to be taxed at higher rates under the AMT. So, even though capital gains and qualified dividends are technically taxed at their usual preferential rates, their presence can cause other income to be taxed at higher marginal rates.
Also note that passive activity gains and losses, depreciation and a number of other items are treated differently under AMT than under the ordinary system. Be sure to discuss these issues with a qualified tax professional.
Knowing whether you have to get on that road
Certain circumstances trigger the AMT, and knowing what to watch for can help you plan how to manage your tax burden. You may be subject to the AMT if you claim a large number of itemized deductions and personal exemptions, if you claim state and local deductions, or if you exercised incentive stock options. The more deductions there are, the more likely you will be subject to the AMT, because these types of deductions have to be added back to income when calculating AMTI.
To find out whether you are subject to the AMT, you must essentially calculate your federal income taxes twice: once under the standard tax system and once under the AMT system. And you don’t really have a choice about which route you take; it’s whichever one yields a higher tax liability.
Fortunately, once you understand the AMT, you can start thinking about steps you may be able to take to avoid it, or to at least optimize your planning if you’re already subject to it. If you’re a high earner, it’s a topic you should address before the next tax season rolls around.