FPA Financial
Planning Perspectives
IS THE ALTERNATIVE MINIMUM TAX IN YOUR FUTURE?
The alternative minimum tax originally was designed as a parallel tax system to the regular income tax to ensure that higher-income taxpayers who take a lot of deductions pay at least a minimum amount of tax. But in recent years, the AMT has started snaring more middle-income taxpayers. The latest Internal Revenue Service figures showed 828,000 taxpayers paid the AMT in 1998—up 25 percent from the year before. A full quarter of those taxpayers reported adjusted gross income below $100,000.
Unless Congress adjusts how the AMT is calculated, extends current AMT tax credits or eliminates the tax as some have proposed, 1.3 million taxpayers in 2000 and 17 million taxpayers in 2010 will pay additional tax under AMT, according to the latest Treasury Department estimates. Taxpayers most likely to trigger the AMT are those taking large deductions in relation to their income, people who have high state or local taxes, taxpayers who have high employee business expense deductions, and people exercising qualified incentive stock options. Are you vulnerable to the AMT—if you’re not paying it already—and what can you do to avoid or minimize it?
First, let’s look briefly at how the AMT works. Taxpayers first calculate their regular income tax. If there’s any question that they may be vulnerable to AMT—tax preparation software will flag this, for example—then they should recalculate their taxes under AMT.
When calculating AMT, you add back certain adjustments and “preferences” that you took when computing the regular income tax. For example, a taxpayer cannot take the standard deduction under AMT. Taxpayers who itemize must add back such adjustment items as the personal and dependent exemptions, state and local taxes (including property taxes), investment interest expense, child care credits, some home equity loans, and that portion of home refinancing that’s higher than the refinanced debt. Charitable deductions and home mortgage interest don’t figure into AMT.
One of the biggest triggers to AMT these days occurs when taxpayers exercise their qualified incentive stock options. Under regular income taxes, you don’t owe any taxes on the spread between the market price and the exercise price until you sell the shares. However, under AMT that spread is treated as income.
After the adjustments and preference items are added back, you basically get to take a single allowable exemption. In the case of married taxpayers filing jointly, it’s $45,000 ($33,750 for singles, $225,000 for marrieds filing separately). However, these exemptions phase out once your alternative minimum taxable income (AMTI) reaches $150,000 on a joint return or $112,500 on a single return.
After the exemption is taken (if you qualify), the first $175,000 of AMTI is multiplied by 26 percent, and anything above that is multiplied by 28 percent. If the resulting tax is higher than what you calculated on your regular income tax, you pay the higher AMT amount. Thus, although the tax rates are lower than the top rates for regular taxpayers, more income is exposed to tax under AMT so the total may actually be higher.
Why are an increasing number of taxpayers, including more middle-income taxpayers, vulnerable to the AMT? For one thing, the exemption amount and the AMTI amounts aren’t indexed for inflation and haven’t been adjusted in several years. Taxpayers also are piling on more deductions in the wake of such tax acts as the 1997 Taxpayer Relief Act, creating a bigger spread between deductions and income. For example, personal tax credits such as the $500 child credit and higher education tuition credits are temporarily exempted from AMT, but only through the 2001 tax year.
Now is the time to start to work with your tax advisor to see if you’re vulnerable and to take possible corrective actions. Planning is especially important because tax strategies used to reduce regular income taxes, such as deferring income and accelerating expenses in a given year, can have the opposite effect on AMT taxes. Also, plans to exercise stock options warrant a close look. It may be better to exercise before or after the end of the year, depending on your circumstances. However, one should always be cautious about basing investment decisions too heavily on tax law.
December 2000— This column is produced by the Financial
Planning Association, the membership organization for the financial planning
community, and is provided by Rich
Chambers, CFP, a local member in good standing of the FPA.
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