The Alternative Minimum Tax and How it Might Affect You

Don’t be surprised if you have to pay a “new” tax when you file your federal income tax return this year. The Alternative Minimum Tax (AMT), a tax which was originally created in 1969 to keep the wealthy from avoiding taxes altogether is now affecting many middle class families. Unfortunately, the tax was never adjusted for inflation which means a $100,000 income earner in 1969 is equivalent to earning more than $410,000 in 2005 assuming 4% inflation. Families earning between $100,000 and $200,000 are twice as likely to get hit with this tax than millionaires

The Alternative Minimum Tax is considered one of the most difficult and complex areas of tax law. In summary, it disallows many of your usual tax deductions. It reduces the amount of your personal exemptions, state taxes and home loans. For most people, these deductions are the ones that give you the ability to itemize rather than to simply take the standard deduction. The AMT is a separate tax system that must be compared to your normal income tax calculation. You then have to pay the higher of the two calculations. The National Taxpayer Advocate estimates nearly 3 million AMT taxpayers paid on average an additional $6,000 in 2004.

An even more frightening statistic is by 2010 an estimated 89% of families earning between $75,000 and $100,000, which is certainly not considered wealthy by today’s standards, will be forced to pay the AMT.2 There are multiple complex factors which trigger the AMT. Some not-so-complicated factors which increase your exposure are:

• Claiming a large number of personal and dependent exemptions
• Using home mortgage or equity line of credit proceeds to do something other than to buy, build or improve your home
• Exercising incentive stock options and not disposing of the stock in 2005

So what can you do to minimize your risk of paying Alternative Minimum Tax? You can start with being careful to use your home mortgage and line of credit for repairs and/or improvements to your home. When it comes to incentive stock options, if it makes sense, dispose of the stock you receive when exercising your options in the tax year which you receive it. Just be careful to not let the tail wag the dog and sell a stock that might be a good long-term hold or might generate a short-term capital gain which can be taxed at a higher rate. Talk to your tax preparer about other tax preference items which can help minimize AMT. If you have the ability to reduce your income such as deferring more income to the 401(k), receiving deferred compensation, or owning tax-deferred investments, take advantage.

In the end, your tax-preparer and financial advisor should work together to make sure you not only minimize your tax exposure but also to ensure you are meeting your financial objectives as well.

^{Burman, Leonard E. The Individual Alternative Minimum Tax. President’s Advisory Panel on Federal Tax Reform March 3, 2005. 2 Burman, Leonard E., Gale, William G & Rohaly, Jeffrey (2005). The Expanding Reach of the Individual Alternative Minimum Tax, 4.}