This year many taxpayers were faced with the unwelcome surprise of Alternative Minimum Tax on their income tax return. Alternative Minimum Tax (AMT) is a complex, parallel income tax system to the standard income tax calculation. AMT was started in 1969 in an attempt to prevent very wealthy people from using large deductions and exemptions to avoid paying income tax. At that time it was discovered that 155 households with income over $200,000 were able to avoid paying any income tax. AMT was originally aimed at the very rich but over the years it has come to impact millions of middle and upper income taxpayers.
Until you are hit with AMT, you may be unaware that behind the scenes your tax software runs two sets of numbers to determine how much income tax you will owe. Your return is calculated using the standard income tax rules and it is calculated using the AMT rules.
AMT recalculates your taxable income by adding back many commonly used deductions and exemptions. Some of the most common AMT add-backs include state and local taxes including real estate taxes, miscellaneous itemized deductions, home equity loan interest that isn’t used to buy or improve a home, and medical expenses. AMT also adds back exemptions for dependents and the standard deduction, if you don’t itemize. Tax-exempt interest from most private activity bonds becomes taxable under AMT and if you exercise Incentive Stock Options, the gain becomes taxable upon exercise. Under the standard income tax calculation, tax is due when the stock is sold.
If there is a possibility you will be subject to AMT, I recommend having your taxes professionally prepared or using tax preparation software. Your software will calculate AMT by adding the items listed above to your adjusted gross income to arrive at your Alternative Minimum Tax Income (AMTI). You are allowed to exempt some of your income from AMTI. For 2016 the exemption for single filers is $53,900 and for joint filers is $83,800, the exemption is reduced for higher income taxpayers. AMT is calculated by subtracting your exemption from your AMTI and multiplying your first $186,300 by 26% and anything over $186,300 by 28%, these figures are adjusted every year. Your total income tax for the year will be the higher of your standard income tax calculation or AMT.
Taxpayers who are most likely to fall into AMT are those who live in a state with high income taxes, those with high deductions and those with large families. While there are limited opportunities to reduce the likelihood of paying AMT, one option is to reduce your adjusted gross income by maximizing tax deferred retirement plans such as 401k and 403b plans. You also may be able to reduce AMT by moving to a state with no or low income tax or by managing the timing on when you pay state and local taxes.