A stealth tax that may kill your tax breaks
The tax cuts of 2003 have provided a welcome break for middle and upper-income taxpayers. But your tax benefits may be cut short if you fall victim to the Alternative Minimum Tax (AMT).
The AMT is a substitute tax applied to people who are lucky or shrewd enough to reduce their taxes below what the federal government deems fair. Before filing a return, you must figure this tax using a different set of income and deduction rules—and pay the amount if it exceeds your regular tax calculated on Form 1040.
When the AMT was created in 1969, only high income taxpayers who loaded up on deductions and exploited loopholes had to worry. But the AMT has been steadily consuming more and more upper-middle class taxpayers.(1) This tax creep has occurred for two main reasons: The program was never indexed for inflation and AMT tax rates have remained in place while marginal tax rates have dropped. As personal income and deductions have risen over the last three decades, more people have been caught in the trap.
If you make $100,000 or more annually, you may be exposed to the AMT now or in future years. Although many consider the AMT unfair, it won’t likely disappear because the federal government cannot afford to give up the revenues in a time of rising budget deficits.(2)
Figuring the tax
The AMT operates in a parallel universe to the regular tax rules. After completing your Form 1040, you calculate the AMT using Form 6251. You compare the taxes owed under both scenarios and pay the higher amount. Personal taxable income under the AMT typically is higher because most itemized deductions are disallowed. These include state and local taxes, property taxes, dependents, unreimbursed business expenses and other items. Only deductions for home mortgage interest and charitable contributions survive.(3)
Although the marginal rates for AMT—26% and 28%—are lower than personal rates, the final tax often is higher under the AMT since the rate is applied to a higher adjusted income. On average, taxpayers who are caught in the AMT squeeze pay an additional $10,000 in tax.
To make matters worse, tax cuts in 2001 and 2003 have pushed more taxpayers into the AMT’s hazard zone. Although the laws reduced marginal tax rates in the regular tax system, the AMT brackets were not revised. Lower federal tax rates, combined with higher itemized deductions (due to rising state taxes and property taxes), may create a more likely AMT situation for a taxpayer whose income is climbing.(4)
There is no reliable method to predict exposure to the AMT. This makes annual tax planning essential. As the year unfolds, you can project total income and deductions—and consider various tax rate scenarios you may encounter. Then, take available action to avoid stepping over the AMT line.
Certain risk factors will push you closer to that line. These may include:
Itemized deductions: It bears repeating: Most ordinary tax deductions don’t apply in the AMT formula. Your exposure increases if you are married, have several children, pay high state income and local property tax, and have other large deductions, such as unreimbursed business expenses.
Income level: Beware if your income has risen sharply. The AMT exempts the first portion of income.(5) But this exemption phases out, beginning at $150,000 for married couples and $112,500 for singles. For every extra dollar earned, it phases out 25¢. So, in 2003, the exemption disappears at $382,000 for marrieds and $273,500 for singles.
Dividends and capital gains: The new 15% rate on dividends and long-term gains applies in the AMT. But you get less benefit as your income rises. If you have hit the phaseout range described above, each additional $1 capital gain adds $1.25 to the AMT income on which you will be taxed.
Incentive stock options: Under the normal IRS rules, you can exercise stock options, hold the stock for a year and pay 15% gains tax when you sell the stock. However, you must report an adjustment of your paper gain when the options are exercised. This can trigger the AMT. And if the stock price plummets before you sell, tax is owed on the price at the time of exercise. Avoid this by exercising smaller amounts and selling enough to cover your taxes.
Note: This is a summary of the Alternative Minimum Tax (AMT) and is not intended to address all relevant facts, details and exceptions relating to the tax rules. Seek out qualified tax counsel to help review your current situation and to assess how the AMT may influence your decisions.
(1) The AMT originally targeted a small group of aggressive filers who made $200,000 or more per year and were paying zero tax. But the AMT steadily advanced into the mainstream, affecting 132,000 taxpayers by 1990, 1.3 million in 2000 and 2.4 million in 2003. If the rules are not changed, it will apply to an estimated 12.7 million taxpayers by 2005 and 33 million by 2010. That encompasses about 95% of taxpayers with incomes from $100,000 to $500,000—and one of every three Americans who file a return. (“Taxpayer Beware!”, Fortune, 23 June 2003, p 50.)
(2) The AMT accounted for about 2% of all federal tax receipts in 2003—about $16 billion. By 2010, the collections from this tax will equal an estimated 1% of GDP—or about $124 billion. That’s equal to about 55% of the total income earned in the U.S.
(3) The calculation: Take your regular taxable income figured on Form 1040 and add back all deductions except mortgage interest and charitable contributions. Then subtract the exemption from AMT (e.g., $58,000 for married joint filers in 2003). The adjusted number is income subject to AMT. A 26% tax rate applies to the first $175,000 and 28% to the remainder. If your liability under the AMT is higher than your regular tax, you pay the higher amount.
(4) Property and state income taxes are rising steeply around the country—and the trend is expected to worsen as state and local governments struggle to balance their budgets. A taxpayer can deduct state and local levies when calculating federal income tax. This benefit has mitigated the effect of higher taxes. But these deductions are not allowed under the AMT. People who are exposed to the AMT take a double hit: They pay higher federal tax and feel the full burden of rising taxes at the local and state levels.
(5) In 2004, the AMT exemption drops from $58,000 to $45,000 (married joint filers), and from $40,250 to $33,750 for single filers. (“The Tax of Unintended Consequences”, Money, 8 Sept. 2003, p 89.)