By Geoffrey M. Zimmerman, CFP
Learn more about Geoffrey on NerdWallet’s Ask an Advisor
If you got hit by the federal alternative minimum tax last year or think you might get hit this year, now is the time to think about your tax planning. There may still be some ways you can escape the AMT. Talk to your tax professional about the best strategy for you, but one way to avoid the AMT is to reduce your alternative minimum taxable income (AMTI) to the point where the AMT is less than the ordinary tax.
How it works
The AMT is an alternative method of calculating income tax that runs parallel to the regular tax system. Under the regular system, taxable income largely drives what tax bracket you fall into. I’ll call this “regular taxable income” (RTI). With the AMT, certain types of income, exemptions and itemized deductions also factor into your taxable income amount. You must calculate both your RTI and your AMTI to determine your tax liability under each system. Then you pay whichever is higher.
To find your AMTI, calculate your RTI and then add certain types of income that normally aren’t included. Examples include income from the exercise of incentive stock options, tax-exempt interest on industrial revenue bonds — a certain type of municipal bond — and depreciation. You also add back certain deductions such as property taxes, state income taxes, depreciation and interest on home equity loans. Finally, while deductions for medical expenses are still allowed, the threshold for claiming the deduction under AMT is higher than under RTI. So, under the AMT, fewer of your medical expenses will be deductible.
All of the above are examples of AMT preference items. The greater the number and amount of preference items you have relative to your income, the more likely you are to be hit by the AMT.
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Escaping the AMT
Avoiding the AMT will involve either strategies that reduce both your RTI and your AMTI or strategies that reduce your AMTI relative to your RTI. Talk with your advisor about the following:
Retirement contributions: Maximize your contributions to qualified retirement plans such as your 401(k). The contributions reduce your adjusted gross income as well as your taxable income, regardless of whether you’re hit by the AMT. Reducing your AGI can be important, because as your AGI rises, your ability to use itemized deductions is slowly reduced. Qualified plan contributions also help you save for retirement.
Deferred compensation: If your company offers you access to a nonqualified deferred-compensation plan — essentially a promise by the employer to hold on to the assets until a future point in time — you may want to elect to defer income into the plan. By deferring compensation, you also defer taxation on the amount contributed to the plan, plus any growth, until you withdraw the money, typically when you leave your job or retire. The election to defer income normally doesn’t take effect until the next year, but it may still affect year-end planning for the current year. Work with your advisor to weigh the pros and cons of this income-reduction strategy.
Itemized deductions: The type, number and amount of deductions you take are key factors in determining whether you must pay the AMT or the regular income tax. Consider deferring certain itemized deductions if you fall under the AMT. For example, state income taxes can be an itemized deduction under ordinary tax but not under the AMT. If you’re making estimated tax payments, your fourth-quarter payment is due on or before Jan. 15. So if you review your tax situation in December and find that you’re going to fall under the AMT in the current year but possibly not in the following year, you would choose to defer that state tax payment until after Jan. 1, instead of making it this year.
Charitable contributions: If this year is an abnormally high income year, pushing you into the AMT, consider making a larger than normal donation. This is known as “bunching” several years’ worth of charitable contributions. You can give either directly to charities or through a donor-advised fund offered by a broker or a community foundation. Donations to these funds are deductible in the year of contribution, and once you’ve made the donation, the money may be distributed to charitable organizations over time according to your wishes.
Incentive stock options: With incentive stock options, you generally don’t have to pay ordinary income tax on the difference between the option strike price (the exercise price in your contract) and the stock price on the date of exercise. This is known as the bargain element. If you’ve exercised and held ISOs in the current year and expect to be subject to the AMT, consider selling some or all of the stock before the end of the year. If you sell the stock before you meet the qualifying holding periods — at least two years from grant date and at least one year from the date of exercise — the sale results in a disqualifying disposition. This makes the portion of the revenue attributable to the bargain element RTI, not an AMT preference item.
If you’re going to do a disqualifying disposition to help reduce AMT, you must do it in the same year as the exercise. An exercise of an ISO could trigger both the AMT, in the year of exercise, and an ordinary income tax event, if you sell stock in the calendar year after the year of exercise but before you meet the qualifying holding periods.
If you find at the end of the current calendar year that you are subject to the AMT, and you’ve decided to continue holding the stock purchased through the exercise of an ISO, make sure you have enough money set aside (in particular, to pay your tax bill or meet other short-term obligations) without having to sell the stock as a disqualifying disposition.
Other strategies: You should also look for other ways to reduce your tax burden under the AMT and regular tax system. For instance, you can invest in tax-free municipal bonds (but avoiding industrial revenue bonds), rather than in taxable bonds, or you can enroll in your employer’s pretax medical-deduction plan to help reduce your salary.
Meet with your tax professional and financial advisor to assess your level of AMT risk and find ways to avoid it or reduce the impact. Make an appointment for a year-end tax-planning meeting in November or early December. By then, you’ll have a pretty good idea of what your income, itemized deductions and exposure to preference items will look like for the year and what more you can do before the tax year ends.