For millions of American taxpayers, the most dreaded three-letter acronym this time of year is no longer IRS. These days, it’s just as likely to be AMT.
The AMT, or Alternative Minimum Tax, is more than a mere tax. It’s a different way of calculating your tax liability, one that disallows or reduces exemptions and deductions that would otherwise work to your benefit. Consider it the normal tax system’s evil twin.
You may think your children entitle you to exemptions or your property taxes will earn you a deduction, but with the AMT, you could have another thing — and possibly a whopping tax bill — coming. Because the calculation happens behind the scenes at your tax preparer’s office or behind the screens if you use tax software, you may not even know what hit you.
After determining your tax liability both the normal way and the AMT way, you'll have to pay whichever is higher. There's no specific income threshold at which the AMT kicks in, but taxpayers with incomes between $200,000 and $500,000 currently appear to be the most vulnerable.
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The Irony of the AMT
Tax experts have long decried the irony that the AMT, created in 1969 to ensure that very wealthy taxpayers paid their fair share, or at least something, now ensnares millions of upper middle-class Americans. Elected officials often decry it too, but the law lives on, perhaps because it brings in so much revenue: close to $30 billion this year, according to the Tax Policy Center.
So what, if anything, can you do to escape the AMT or lessen its impact?
8 Ways to Lessen the AMT's Impact
Next Avenue put that question to half a dozen financial planners and other experts who deal with the AMT on a regular basis. Here are eight of their suggestions:
1. Max out your 401(k). If you aren’t already contributing as much as you can to a 401(k) or similar plan, here’s another reason why you should. Reducing your taxable income may help lessen your AMT exposure, notes David Wirth, a certified financial planner with Savant Capital Management in McLean, Va.
For 2015, the maximum 401(k) contribution is $18,000 for anyone under 50; $24,000 for 50-plussers.
2. Don’t bunch up taxes. Prepaying your property taxes — for example by paying a January bill in December to increase your deductions for that year — can often be a smart tax-saving move. Except, that is, if you’re subject to the AMT.
The AMT could disallow your property tax deduction entirely, negating any benefit, points out Chris Cooper, a certified financial planner in San Diego, Calif. Plus, if it turns out that you aren't subject to the AMT the following year, you’ll have lost a potential deduction.
3. Watch those muni funds. Tax-free municipal bond funds aren’t truly tax-free under the AMT if they hold any “private activity” bonds. Those are bonds issued by states and municipalities for nongovernmental purposes, such as building a new stadium. The 1099-DIV you receive from the fund at tax time will indicate the amount of its distributions subject to the AMT.
If you’re shopping for a new muni bond fund and are concerned about the AMT, consider one that advertises itself as AMT-free, as many now do.
4. Time your stock options. If your employer provides incentive stock options (ISOs), allowing you to buy company stock at a fixed, and often bargain, price, that’s usually a good thing. Under normal, non-AMT circumstances, when you “exercise” your options and buy the shares, you won’t face any tax until you later sell. But… if the AMT kicks in, you’ll owe taxes on the difference between the shares’ value and what you paid for them, whether you sell them or not.
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If a lot of money is involved, it’s worth paying a tax adviser to run various scenarios to see how best to reap a profit and also cover the resulting tax bill. Note, too, that if you pay the AMT on your stock options, you’ll be eligible for a credit in a future year when you aren’t subject to the AMT.
5. Be careful with home-equity loans. The interest you pay on a home-equity loan is normally tax-deductible. That can make it a relatively inexpensive way to borrow money to pay college or medical bills or for major purchases, like a car. However, the AMT lets you deduct the interest only if you use the money for home improvements. So before you decide that a home-equity loan is your best choice, consider what it would cost with and without a tax deduction, just in case.
6. File a Schedule C if you can. If you have self-employment income and file a Schedule C (“Profit or Loss From Business”) with your tax return, that may help lighten your AMT load. The deductions you claim on Schedule C aren’t affected by the AMT.
Wirth, who suggests small business owners get the advice of a tax pro, says Schedule C filers sometimes overlook claiming travel and office expenses as well as legal and professional fees. If your business made non-cash charitable donations, those may also be deductible, Wirth says.
Other experts suggest that people with home offices consider prorating their property taxes and deducting the applicable percentage of them on Schedule C. That way, they won't lose their entire property tax deduction to the AMT.
7. Consider a partial Roth IRA conversion. If you’re a high earner whose top income is normally taxed at the marginal rate of 39.6 percent, triggering the AMT could provide an opportunity for what Scott F. Demler, a certified financial planner with Savant Capital Management in Rockford, Ill., calls a “cheap” Roth conversion. The money you convert would be taxed at the AMT rate of 28 percent instead of your usual 39.6 percent.
But, Demler cautions, you must make the conversion by December 31. So it’s best to check with your tax adviser well before then to see how much money you could convert at the lower rate.
Why might you want to convert a traditional IRA into a Roth IRA? For one thing, withdrawals from a Roth are tax-free, which could be beneficial, especially if tax rates rise. For another, unlike a traditional IRA, a Roth isn’t subject to the government’s Required Minimum Distributions once you reach age 70 ½. So if you don’t need the money for living expenses, you can pass it along to your heirs.
8. Just move. Several planners suggested that the AMT-averse simply pack up and head to a state with no income tax and low property taxes. You might not want to go quite that far merely to escape the AMT. But if you’re planning to relocate anyway, such as to new digs for retirement, it’s worth investigating.
Bear in mind, of course, that states tax things besides incomes and real estate, so you need to consider your total potential tax burden. The Retirement Living Information Center site has a helpful breakdown of taxes by state. You can also consult a state’s tax or revenue department site.
As you may have gathered, the AMT can be devilishly complicated, even by tax-law standards. So if you’re worried about it, consider consulting a knowledgeable pro. You can also get guidance from the IRS’s online AMT Tax Assistant.
Greg Daugherty is a personal finance writer specializing in retirement who has written frequently for Next Avenue. He was formerly editor-in-chief at Reader’s Digest New Choices and senior editor at Money.