Did you know that you're supposed to calculate your income taxes two different ways? First, you figure your tax liability under the regular tax system, which factors in preferential treatment of some income and allows tax credits for certain types of expenses. Then you calculate your taxes using the rules for the alternative minimum tax (AMT), which eliminates some tax deductions and credits. If the AMT is higher, you will be subject to taxes in addition to your regular income tax. Read on to learn more about reducing your AMT. (To continue reading about taxes, see Tax Tips For The Individual Investor.)
Tutorial: Personal Income Tax Guide
What Is the AMT?
The AMT was instituted in the late 1960s to ensure that high-income individuals pay at least a minimum amount of taxes. However, one of the challenges with the AMT is that an increasing number of middle-income taxpayers are finding themselves paying this tax. This is because while most other aspects of the federal income tax system have been indexed for inflation over the years, the AMT brackets have remained relatively constant. Further, while the top tax bracket has been cut to 35%, the AMT rates have held steady at 26% and 28%. As a result, the AMT is no longer a tax just for the wealthy. (Note: Though 26% and 28% are the statutory rates, the actual rate structure is 26%, 28%, 32.5% and 35%.)
If you owe AMT, you may be able to lower your total tax by claiming itemized deductions on Form 1040, even if your total itemized deductions are less than the standard deduction. This is because the standard deduction is not allowed for the AMT and, if you claim the standard deduction on Form 1040, you cannot claim itemized deductions for the AMT. Check with your tax professional to be sure. (For related reading, see Why You Should Itemize Your Deductions.)
Should You Worry About the AMT?
It appears there is cause to worry about whether you will be subject to the AMT, as it is affecting an increasing number of taxpayers. According to the Congressional Budget Office (CBO), "… about 27 million taxpayers (see figure below) - one out of every six taxpayers - will be affected by the AMT in 2010, paying on average an additional $3,900 in tax. Nearly every married taxpayer with income between $100,000 and $500,000 will owe some alternative tax."
|Figure 1: Tax returns affected by the alternative minimum tax (millions)|
|Source: Congressional Budget Office|
The following table, issued by the CBO, shows its projection of the number of taxpayers that will be affected by the AMT.
|Figure 2: Taxpayers with AMT liability, by adjusted gross income in 2005 dollars, calendar years 2001 to 2014 (percentage)|
|Source: Congressional Budget Office|
The CBO also projected that married couples are more likely to be subject to the AMT. The following table shows its projection of married and single taxpayers that will be affected by the AMT, based on their number of dependents.
|Figure 3: Percentage of taxpayers projected to pay AMT in 2010, by marital status and number of dependents. The CBO projects that in 2010, there will be 100 million unmarried and 60 million married taxpayers.|
|Source: Congressional Budget Office|
So, the question then becomes, "Are you a candidate to be hit by the AMT?" Consider that your chances of paying this tax increases, if you:
- Have a large family
- Live in an area with high real estate taxes and/or high state and local income taxes
- Claim significant miscellaneous itemized deductions including investment expenses or un-reimbursed employee business expenses.
- Exercise and hold incentive stock options (ISOs)
- Realize significant long-term capital gains
Exemption Amounts for AMT
For 2010, the exemption amounts are:
- Single: $33,750
- Married filing jointly or qualifying widow: $45,000
- Head of household: $33,750
- Married filing separately: $22,500
As a result, you may have to pay the AMT if your regular taxes, combined with certain adjustments and tax preference items, are more than these amounts.
How to Reduce the AMT
One way to minimize the AMT is to reduce your adjusted gross income (AGI). If you participate in a 401(k), 403(b), SARSEP, 457(b) plan or SIMPLE IRA, consider making the maximum allowable salary deferral contributions to your account to reduce your taxable income for both taxes. If your employer offers a cafeteria plan, look into whether you could reduce your taxable income even further by paying for medical insurance, dental insurance, life and disability insurance, and even dependent care expenses through the plan.
If you are self-employed, claiming your business expenses directly against your self-employment income on the Schedule C instead of as a miscellaneous itemized deduction on the Schedule A reduces your AGI and also ensures that you won't lose any of these deductions to the AMT. Plus, contributing to a SEP IRA, SIMPLE IRA, Solo 401(k) or other qualified plan also helps minimize the impact of this tax.
Self-employed individuals who claim a home office deduction can also reduce the AMT they end up paying. The home office deduction offsets your net self-employment earnings, which reduces your AGI. And while real estate taxes reported as an itemized deduction aren't allowable when calculating the AMT, claiming the home office deduction moves a portion of those taxes against your self-employment income to where they are unaffected by the AMT.
Do you have a sizable investment portfolio outside of your tax-deferred accounts? If so, consider switching to tax-efficient mutual funds and tax-exempt bonds or bond funds as a way to decrease your AGI.
Don't forget that with the AMT, timing is everything. Try to pay your real estate taxes and your state and local income taxes in years that your income might fall outside the AMT range.
To determine whether you are subject to the AMT, you will need to complete Form 6251. Before working through the numbers, visit the IRS's website, where you can download the current year's Form 6251 along with instructions. While you're there, test drive the IRS's new "AMT Assistant" tool, which will help you determine whether you need to file Form 6251 in the first place.
The Bottom Line
Calculating your AMT, or even determining whether you are in fact subject to it, is a complicated process. This article is just an introduction to the subject matter and cannot give you a complete understanding of AMT and how it may affect your taxes. Therefore, unless you are an expert at tax preparation and have a complete understanding of how the AMT works, it may be in your best interest to have your tax return prepared, or at least reviewed, by an expert tax professional who will be able to determine whether you owe the AMT, are eligible for exemptions and are eligible to claim AMT credits for any year - including previous years.
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