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Why Am I Paying the Alternative Minimum Tax?

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The Alternative Minimum Tax, or AMT, made its debut to the tax code in 1982. The AMT was originally designed to prevent high-income taxpayers from using too many loopholes and deductions to avoid paying taxes. When the AMT was originally enacted, it wasn’t indexed to inflation, which, as years have passed, has resulted in the tax ensnaring many middle-income taxpayers. In 2012, legislation was passed correcting the inflation indexing issue and thus preventing the “middle-class AMT creep” in future years.

In order to plan for the AMT, it helps to have a brief overview of how it works and what tax items cause this additional tax to be triggered. The AMT is essentially a parallel tax system. After one’s regular tax is calculated, a separate tax calculation under the AMT system must be calculated, and the higher amount is owed. This is usually done by adding back deductions, also known as “preference items,” into the calculation and then applying a flat tax rate to the new income calculation.

Common causes of AMT

  • High deductions for state and local tax – Living in a high tax state such as California or New York can make the AMT tougher to avoid. Income taxes, real estate taxes, and personal property taxes are all added to the AMT calculation.
  • Having many personal exemptions – For example, a married couple with four children will have $23,700 ($3,950 times 6) added back to their income for the AMT calculation.
  • Incentive Stock Options – When exercising incentive stock options, the discount between the stock purchase price and the market price of the stock, also called the spread, is added to the AMT calculation. Therefore, even though no income or cash was received, the spread can cause a tax liability.
  • Home Equity Interest – Home equity loans that aren’t used for acquiring, constructing, or substantially improving a residence get added back for AMT. Thinking of doing a cash-out refinance to pay down personal debt?       That may not be deductible when you factor in AMT.
  • Certain municipal bond income – Interest from municipal bonds known as “private activity bonds” are tax-exempt from income, but get added back for AMT purposes.

Minimizing AMT

Any move that reduces your adjusted gross income (AGI) can help reduce or avoid the AMT. Common ways to cut AGI include:

  • 401(k) contributions
  • Health care withholdings, such as HSA contributions and FSA contributions
  • Contributions to a dependent care FSA
  • Deductible IRA contributions
  • Harvesting investment accounts to create losses in one year, and defer gains to future years.

The best way to avoid or minimize the AMT is through annual tax planning. By being proactive with your planning, you can take steps such to limit exposure to other AMT “add backs.” A little bit of time spent now can help avoid an unpleasant surprise on April 15.

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