If you’ve been doing your research on tax credits and deductions, some of the sources that you’ve come across might mention that you’ll want to watch out for the AMT when using them. The alternative minimum tax (AMT) system is intended for higher-income taxpayers, but over time has come to affect middle-class families as well, and if you trigger it, it can be very expensive.
Let’s take a look at what the AMT is, why you need to be aware of it, and how it can be triggered.
Why is there an Alternative Minimum Tax?
The alternative minimum tax was added to the tax code in 1969, and its present form was created in 1982. It is an alternate system of calculating the income tax that you owe, in which many credits and deductions are phased out when your income is very high. The AMT’s purpose is to ensure that everyone pays a certain minimum amount of income tax – essentially making sure that high-income taxpayers cannot manipulate the tax code through excessive use of deductions and credits such that they pay very little or no tax on a large amount of income.
Originally, this system was intended to only affect individuals or couples with very high incomes, but since it was not indexed to inflation, that amount hasn’t gone up over time. Congress adds a “patch” to the AMT system every few years to increase the exemption amount, but the value of many credits and deductions have gone up over the years as well. Without these patches, it is estimated that 80% of taxpayers who make between $80,000 and $200,000 would owe extra taxes under the AMT system. Over the years, more and more middle-income taxpayers, especially those with multiple children or those who live in states with high incomes taxes, are required to pay the amount they owe under the AMT system instead of the normal income tax system.
What Exactly is the Alternative Minimum Tax?
The AMT is not an additional tax, but actually an entirely separate system of determining how much income tax you owe each year. Your tax program (or accountant) will usually calculate your taxes due in both the regular tax system and the AMT system simultaneously, and you’ll pay whichever calculation is higher. Under the AMT system, your taxable income is subject to a flat tax rate, either 26% or 28% – which is actually lower than the top income tax rate. And, unlike the regular tax system, a much larger amount of your income is exempt from taxation right from the start.
In 2011, the exemption amounts are $48,450 for single or head of household taxpayers, $74,450 for married filing jointly, and $37,225 for married filing separately. (For 2012, the exemption amounts decrease to $33,750 for single or head of household taxpayers, $45,000 for married filing jointly, and only $22,500 for married filing separately.) After you take the exemption that you qualify for based on your filing status, many of your deductions – such as personal exemptions – will be added back to your taxable income. When you calculate the AMT (using IRS Form 6251 – click here for form instructions) you’ll take your original AGI from your Form 1040, add a bunch of deductions back to your income (see below), subtract your exemption, and then calculate the flat tax on what’s left. You then compare that tax liability to what was calculated under the regular tax system, and pay whichever is higher. In general, taxpayers who pay the amount calculated by the AMT pay $2,000 or more in taxes than they would have if they paid the amount calculated by using the regular tax rules.
In general, the AMT system will calculate a higher tax than the regular tax system if you make a lot of money or have a lot of deductions. But if you have lower income or don’t take a lot of deductions, you’ll pay more tax with the regular income tax system, and you’ll be required to pay whichever amount is higher. There is no specific income number at which you’ll start being required to pay AMT, since it depends on your total income, your filing status, your dependents and other deductions.
Tax Deductions Affected by the AMT
There are several common types of deductions that you can’t take under the AMT system. These include:
State Income Tax
Under the normal income tax rules, you’re able to deduct the income taxes you paid to your state, but under AMT rules, you can’t. If you live in a state like New York or California which has very high income taxes, you might not realize just how much of a deduction you’re getting from taking those taxes out of your income, but the AMT rules add them back in.
For each person (including yourself and your spouse) that you support, you’re generally entitled to deduct $3,650 from your taxable income. Under the AMT system, you can’t take those deductions. If you have multiple children, you’ll lose an even bigger chunk – for example, if you are married with two children, you’d be taxed on an extra $14,600 ($3,650 x 4) under the AMT tax rules than you would be under the regular income tax system. If you have four children, you’d be taxed on an extra $21,900.
The AMT does allow you to take itemized deductions (thanks to another patch from Congress) but not all of the entries on the itemized deductions list can be used. Medical expenses – where normally you’d be able to add the amount that’s higher than 7.5% of your AGI to your itemized deduction – aren’t allowed to be deducted under the AMT system. You also aren’t able to deduct miscellaneous itemized deductions (which includes things like unreimbursed business expenses or tax preparation fees) under the AMT rules.
Interest Paid On a Home Equity Line
You’re still able to deduct the interest paid on your primary home’s mortgage under the AMT rules, but when calculating under the AMT system you won’t be able to deduct the interest that you paid on the home equity line attached to your principal home.
Will I have to Pay the AMT?
Often, the only thing that people want to know about the alternative minimum tax is whether or not they will have to pay it? Unfortunately, there is no clear answer to that. Whether you will have to pay this higher amount of tax depends on how many tax breaks you’re taking in the above categories, as well as miscellaneous other deductions that aren’t allowed.
If you have a high income and are significantly reducing your taxable income using the above deductions, taking those out would significantly increase the amount of income that you would have to pay taxes on. Therefore, when you calculate your income using the AMT rules as well as the normal tax system rules, you’ll probably come out owing more taxes under the AMT rules. When you calculate your tax liability using both the regular income tax system and the AMT system, you’re required to pay whichever number is higher. It is very difficult to get out of paying the higher taxes under the AMT system, simply because the AMT system was designed to be difficult to get out of.
It’s important to calculate your tax liability under the AMT system each year because if you find out later (hopefully not during an audit) that you really did need to pay that higher amount, you’ll have fees and penalties on top of that extra tax amount. Most tax programs will calculate it for you if you ask, or may do it automatically if your income is very high. If you don’t get a definite message from your tax program or your accountant as to whether or not you might have to pay the higher amount, it’s definitely worth it to ask and save yourself from a hefty tax bill in the future.