Alternative minimum tax: It takes a multiyear plan to manage effectively
Each year, the alternative minimum tax (AMT) reaches more taxpayers as incomes rise and AMT brackets and exemptions stay flat. Originally created to ensure that targeted high-income taxpayers paid a minimum amount of income tax, the AMT only affected 155 taxpayers in 1969, the year it was introduced. By 2010, however, more than 33 million taxpayers were subject to the tax.
Taxpayers are subject to AMT because certain types of income and expenses are treated differently for income tax and alternative minimum tax purposes.
Taxpayers are subject to AMT because certain types of income and expenses are treated differently for income tax and alternative minimum tax purposes. The following are examples of items that can lead to or increase an AMT liability:
- Deductions for state and local income or sales tax
- Personal property or real estate taxes
- Miscellaneous itemized deductions, including investment expenses or unreimbursed employee business expenses
- Significant long-term capital gains and/or qualified dividends
- Incentive stock options (ISOs)
- Schedules K-1 with depreciation adjustments
- Tax-exempt interest from private activity bonds
Planning for AMT
Planning for AMT is complex, but it starts with an understanding of your current tax situation.
If you know you will or will likely be in AMT, there may be an opportunity to accelerate income that might otherwise be taxed at ordinary rates as high as 39.6 percent and recognize it at an AMT rate of 28 percent. You can also benefit by incorporating tax planning into your broader financial and investment planning strategies. For example, it may make sense to reposition your portfolio to contain more taxable investments since it may result in a higher after-tax return. Similarly, taxpayers that are safely out of AMT may choose to invest in private activity bonds that are tax-free for regular income tax purposes and offer higher nominal rates than true tax-exempt bonds. However, private activity bonds are taxable for AMT purposes.
When a year-end projection shows that AMT exposure is likely in one year but potentially not present in another year, taxpayers can “bunch” expenses like state and local and property tax payments or incentive stock option exercises in the non-AMT year. For example, if you’re in AMT in 2016 but may not be in 2017, fourth-quarter 2016 estimated state income tax and first-half 2017 real estate tax payments should be deferred and made in January 2017 to maximize their tax benefit. If the reverse were true, you’d want to accelerate these payments and make them in December 2016.
AMT is a “hidden” tax that impacts many taxpayers. But fear not; opportunities to identify and reduce its impact are available if done prior to year end.