What is Alternative Minimum Tax and How is it Calculated?
Written by: Kristy Welsh
Last Updated: August 17, 2017
Congress enacted the Alternative Minimum Tax to make sure high-income individuals who take advantage of multiple tax breaks would still owe something to Uncle Sam each year. However, the upper-middle-income folks are the ones most likely to be AMT victims.
The AMT was enacted by the Tax Reform Act of 1969, taking effect in 1970. Treasury Secretary Joseph Barr prompted the enactment action with an announcement that 155 high-income households had not paid a dime of federal income taxes. The households had taken advantage of so many tax benefits and deductions that reduced their tax liabilities to zero. Congress responded by creating an add-on tax on high-income households, equal to 10 percent of the sum of tax preferences in excess of $30,000 plus the taxpayer's regular tax liability.
The tax went under several changes through the years, and it current form was currently passed under Tax Equity and Fiscal Responsibility Act of 1982. The law changed the AMT from an add-on tax to its current form: a parallel tax system.
The problem is that the exemptions granted under the AMT have not kept up with inflation, while the average paycheck has. For example, in 1982, the exemption for married couples filing jointly was $40,000. Adjusted for inflation, that would be $95,120 today.
Thankfully, under the American Taxpayer Relief Act of 2012, the AMT will now be annually indexed to keep pace with inflation.
To understand the AMT, let's review a simplistic view of how your taxes are calculated.
- You start with adding up the income on your W-2's and/or 1099's.
- You take whatever deductions you can to minimize your income, for example, the mortgage interest deduction. The smaller your income after deductions, the smaller your taxes.
- Calculate your taxes based on the deducted income.
- You calculate at this point what your alternative minimum taxes are.
- You use the larger of the AMT or taxes calculated with regular deductions.
- At larger incomes, there are fewer deductions to lower the taxable income.
Tax Exemptions and Deductions
Under the AMT, taxpayers are allowed a flat exemption amount but not personal exemptions or the standard deduction. Allowable deductions for the individual under AMT:
- Miscellaneous itemized deductions are not allowed. These include all items subject to the 2 percent floor, such as employee business expenses, tax preparation fees, etc.
- The deduction for charitable contributions of property is limited to the basis of the property.
- The home mortgage interest deduction is limited to interest on purchase money mortgages for a first and second residence.
- Medical expenses may be deducted only if they exceed 10 percent of Adjusted Gross Income, as compared to 7.5 percent for regular tax.
Any move that reduces your adjusted gross income (AGI) might help avoid the AMT. AGI is the number at the bottom of page 1 of your Form 1040. It includes all your taxable income items and is reduced by certain deductions such as the ones for alimony paid to an ex-spouse and moving expenses. Lower AGI means a better chance of claiming a bigger AMT exemption, which will reduce your AMT exposure. Here are some ways to cut your AGI.
How to Avoid or Minimize the AMT
- Make a deductible IRA contribution if you qualify. If you qualify for a 2017 deductible contribution, this is one thing you can do to lower your 2016 AMT bill. The contribution deadline was 4/15/16.
- Contribute the max to your tax-deferred retirement plan at work (typically a 401(k) plan).
- Contribute more to your cafeteria benefit plan and health care and dependent-care flexible spending accounts (FSAs) at work. The contributions will lower your taxable salary, which lowers your AGI and your exposure to the AMT.
- Prepay deductible business expenses near year-end if you run a business as a sole proprietorship, LLC, partnership, or S corporation. The deductions are "passed through" to you, resulting in lower AGI and less exposure to the AMT. Similarly, postponing the receipt of taxable income until next year will also reduce your exposure.
- Consider selling some loser investments held in taxable brokerage firm accounts. You can use the capital losses to offset capital gains, which reduces your AGI and your exposure to the AMT. Any leftover capital losses up to $3,000 are deductible against taxable income from all sources. So your AMT exposure is reduced even further.
- Consider deferring securities sales that will produce taxable gains until next year.
AMT Tax Planning
Devising tax strategies around the alternative minimum tax can be tricky, since the AMT often adjusts for various deductions and credits. In general, tax professionals recommend the following planning tips.
Seek reimbursements from your employer for business expenses incurred as an employee. These expenses are part of the miscellaneous itemized deductions, which are added back to your income for AMT purposes. Having your employer reimburse you for those expenses, by contrast, is a tax-free event to you, and prevents a higher AMT adjustment.
Review your state tax withholding so that you pay in enough so you don't owe but not enough that you substantially overpay. This will keep your state tax deduction to as low as possible, thereby keeping your AMT adjustments as small as possible.
Pay your property taxes when due instead of prepaying your next installment by the end of the year. Again, this will keep your deduction for state and local taxes as low as possible.
Sell exercised incentive stock options in the same year you exercise them. When you exercise & sell incentive stock options in the same year, you'll be subject to the regular tax on the income but not the AMT. However, if you exercise but not sell, the value of the exercised options because income for AMT purposes.