Taking the Mystery Out of Alternative Minimum Tax

office pictures may 2012 002This 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.

Timeless Tips for Investment Success

Jane Young, CFP, EA

Jane Young, CFP, EA

You don’t need to employ a lot of sophisticated techniques and strategies to become a successful investor.  The most effective tools for investment success are simplicity, patience, and discipline.  Below are some guidelines to help you get the most from your investments.

Invest for the long term.  Evaluate your situation, set some goals, create a plan and stick with it.   Keep money that you may need for emergencies and short term living expenses in less volatile investments such as money market accounts, CDs and bonds.   Investments in the stock market should be limited to money that isn’t needed for at least 5 years.  If you keep a long term perspective with the money invested in the stock market you will be less likely to react to short term fluctuations.

Maintain a diversified portfolio.  Your portfolio should be comprised of a variety of different types of investments including stocks, bonds and cash.  The stock portion of your portfolio should include stock mutual funds that invest in companies of different sizes, in different industries and in different geographies.  Don’t chase the latest hot asset class and don’t act on the hot stock tip your buddy shared with you at happy hour.  Create a diversified portfolio and rebalance on an annual basis.  It’s also advisable to avoid investing more than 5% in a single security.

Don’t Time the Market.  Many studies have found that market timing just does not work and can be detrimental to your portfolio.  The so-called experts really have no idea what the market is going to do.  Many analysts earn a living by projecting future market fluctuations when in reality they are no better at predicting the future than you or me.  Peter Lynch sums it up perfectly with the following quote – “More money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

Keep Your Emotions in Check. The stock market is volatile and there will be years with negative returns.   Limit investment in the stock market to money you won’t need for several years.  Have patience and stay the course.  As experienced after the 2008 correction, the market will eventually rebound.  Don’t succumb to media hype and fear tactics claiming things are different this time. There have always been, and always will be, major events that trigger dramatic fluctuations in the stock market.  Don’t panic this will pass.  Sir John Templeton once said, “The four most dangerous words in investing are: “This Time is Different!”

Be tax smart but don’t let taxes drive your portfolio.  Where possible maximize the use of tax advantaged retirement vehicles such as 401k plans and Roth IRAs.  Place investments with the greatest opportunity for long term growth in tax deferred or tax free retirement accounts.   Save taxes where it makes sense but don’t intentionally sacrifice return just to save a few dollars in taxes.

Tax Diversification Can Stretch Retirement Dollars

Jane Young, CFP, EA

Jane Young, CFP, EA

Most investors understand the importance of maintaining a well-diversified asset allocation consisting of a wide variety of stock mutual funds, fixed income investments and real estate.  But you may be less aware of the importance of building a portfolio that provides you with tax diversification.

Tax diversification is achieved by investing money in a variety of accounts that will be taxed differently in retirement.   With traditional retirement vehicles such as 401k plans and traditional IRAs, your contribution is currently deductible from your taxable income, your contribution will grow tax deferred and you will pay regular income taxes upon distribution in retirement.  Generally, you can’t access this money without a penalty before 59 ½ and you must take Required Minimum Distributions at 70 ½. This may be a good option during your peak earning years when your current tax bracket may be higher than it will be in retirement.

Another great vehicle for retirement savings is a Roth IRA or a Roth 401k which is not deductible from your current earnings.  Roth accounts grow tax free and can be withheld tax free in retirement, if held for at least five years. If possible everyone should contribute some money to a Roth and they are especially good for investors who are currently in their lower earning years.

A third common way to save for retirement is in a taxable account.  You invest in a taxable account with after tax money and pay taxes on interest and dividends as they are earned.  Capital gains are generally paid at a lower rate upon the sale of the investment.  In addition to liquidity, some benefits of a taxable account include the absence of limits on contributions, the absence of penalties for early withdrawals and absence of required minimum distributions.

Once you reach retirement it’s beneficial to have some flexibility in the type of account from which you pull retirement funds.  In some years you can minimize income taxes by pulling from a combination of 401k, Roth and taxable accounts to avoid going into a higher income tax bracket.  This may be especially helpful in years when you earn outside income, sell taxable property or take large withdrawals to cover big ticket items like a car.  Another way to save taxes is to spread large taxable distributions over two years.

Additionally, by strategically managing your taxable distributions you may be able to minimize tax on your Social Security benefit.   Your taxable income can also have an impact on deductions for medical expenses and miscellaneous itemized deductions, which must exceed a set percentage of your income to become deductible.  In years with large unreimbursed medical or dental expenses you may want to withdraw less from your taxable accounts.

Finally, there may be major changes to tax rates or the tax code in the future.  A Tax diversified portfolio can provide a hedge against major changes from future tax legislation.

What is Financial Planning?

Jane Young, CFP, EA

Jane Young, CFP, EA

I’m sure you hear the term “Financial Planning” on a regular basis but you may not be sure what it really means.  Financial planning is an on-going, comprehensive process to manage your finances in order to meet your life goals.  The process includes evaluating where you are today, setting goals, developing an action plan to meet your goals and implementing the plan.  Once you have addressed all the areas of your financial plan you should go back and review them on a regular basis.

Financial planning should be comprehensive – covering all areas of your financial life.  The primary areas of your financial plan should include retirement planning, insurance planning, tax planning, estate planning and investment management.    Depending on your situation, your financial plan may also address areas such as budgeting and debt management, college funding, employee benefits, business planning and career planning.  Comprehensive Financial Planning is very thorough and can take a lot of time and energy to complete.  I recommend breaking it into bite size chucks that can be easily evaluated, understood and implemented over the course of time.  

You can work through the financial planning process with a comprehensive financial planner or you can tackle it on your own.  If you decide to hire a financial planner, I encourage you to work with Certified Financial Planner who has taken an oath to work on a fiduciary basis.  An advisor, who works as a fiduciary, takes an oath to put your interests first.

The first step of the financial planning process is to evaluate where you are today.  Tabulate how much money you are currently spending in comparison to your current income.  Calculate your current net worth (assets less liabilities).  Evaluate the state of your current financial situation.  What is keeps you up at night and what should be prioritized for immediate attention?

The next step is to devise a road map on where you would like to go.   Think about your values and set some long term strategic goals.  Using this information develop some financial goals that you would like to achieve.  Once you have identified some financial goals, a plan can be devised to help you achieve them.

Select the area you would like to address first.  Most of my clients start with retirement planning and investment management.  There is a lot of overlap between the different areas of financial planning but try to work through them in small manageable chunks.  Otherwise you may end up with a huge, overwhelming plan that never gets implemented.

Once you have worked through all of the areas in your financial plan you need to go back and revisit them on a regular basis.  Some areas like investments, taxes and retirement planning need to be reviewed annually where other areas like insurance and estate planning can be reviewed less frequently.  Keep in mind that financial planning is an on-going, life long process.

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