What You Need to Know About the Alternative Minimum Tax

A second tax system, supposedly designed to make sure that the very wealthy paid their fair share to Uncle Sam, now penalizes many middle-class Americans who legitimately reduce their tax liability below a certain level.

The alternative minimum tax (AMT), created in 1969 to prevent the rich from benefiting from so many tax breaks that they ended up paying no tax at all, has not been indexed for inflation, which means that more and more average taxpayers are reaching the earnings threshold for AMT every year. The average AMT taxpayer owed an additional $6,000 in tax in 2004.

So, what can you do that might help you avoid, reduce, or at least prepare for AMT’s bite?

First, you need to understand what can trigger AMT. You can be subject to AMT because of one big entry on your tax return, or as the result of a combination of many small factors.

A few of the triggers that increase your odds of having to pay AMT include:

• Living in a high-tax state
• Having a lot of personal exemptions
• Claiming big miscellaneous deductions
• Exercising incentive stock options (ISOs)

Of course, you can’t tell just by looking at a list whether or not you will be subject to AMT.

A quick and easy way to tell if you have been approaching AMT territory is to check your completed Form 6251, Alternative minimum tax--Individuals from last year. Compare the “tentative minimum tax” amount on line 33 to your regular tax liability on line 34--if the gap between those numbers is small, if you don’t have a completed Form 6251 to refer to, or if you have a very different financial picture now, you’ll want to run a projection to see if you’ll be hit this year.

The spreadsheet calculator (or work sheet—use one or the other) provided at that AMT Advisor Web site (http://www.amtadvisor.com/AMTtest.html) is one tool you can use to run the numbers. Be sure to read and follow the instructions carefully.

Another option, if you used TurboTax to complete last year’s return, is to use the software’s planning tools to predict your AMT liability. The first tool is a What-If Work Sheet; the second is the Life Events Planner. Experiment with different scenarios. (Remember, before you can determine if you owe AMT, you must always first calculate your regular tax using Form 1040.)

If you’d rather hire someone to handle your tax return, choose someone who really understands the complex area of AMT.

If you find out you’re going to be hit with the AMT, be aware that the normal tax-planning rules are reversed: Instead of deferring income and accelerating deductions, your new game plan should be to accelerate income and defer deductions.

Why? Because in a year when you’re subject to AMT, all those coveted deductions (such as state and property taxes, miscellaneous deductions, and so forth) that are considered AMT “preferences” become worthless. And any income is going to be taxed at a flat 26% or 28% rate. If you’re in a higher tax bracket under the non-AMT computation, income acceleration in an AMT year may, ultimately, save you money.

So, how can you turn the numbers in your favor when you have to pay AMT? Here are just a few of the ways:

• Try to time state, local and property taxes to be paid in years when you won’t face AMT.
• Try to time payment for medical expenses for a non-AMT year. Or take advantage of a pre-tax medical cafeteria plan if your employer offers one.
• Time your capital gains.
• Use tax-planning software or consult a tax pro before exercising stock options.
• Make a large cash contribution to your favorite charity.
• Accelerate income through such things as prepayment of job earnings and retirement account withdrawals

Consult your tax advisor for additional detail.