Tax time is upon us once again, and for many, that means facing the dreaded alternative minimum tax (AMT).
AMT was instituted in 1969 as a way to prevent those instances in which very wealthy people used deductions to escape paying any federal taxes. Unfortunately, the legislation is now capturing a growing number of middle-class families. The basic problem with AMT is that it was not designed to take into account inflation and the rising cost of living. Because of those forces, it now applies to hundreds of thousands of middle-class families.
The alternative minimum tax typically falls on families earning between $150,000 and $600,000 of annual income. In essence, AMT is a separate income tax calculation. To determine whether AMT applies to you, you must first figure your “regular” tax liability and then figure your liability under the AMT system. If your AMT is higher than your regular tax liability, you must add the difference to your total tax bill.
Calculating your AMT can lead to confusion because it disallows so many of the deductions that are permitted in the ordinary tax system. Those include your standard deduction, personal exemption, exemptions for dependents, deductions for interest on certain home equity loans, and miscellaneous itemized deductions.
One of the toughest aspects of the AMT calculation is that it also eliminates deductions for state taxes. If you live in California (a high income tax state) and earn, say, $350,000, your state tax could be $30,000. Under AMT, you lose that entire write-off, and as a result your Federal income tax could rise quite a bit. Meanwhile your cousin in Texas, which does not have a state income tax, doesn’t have that deduction to lose.
Understanding how AMT works can help certain taxpayers to steer clear of it. However, we do not recommend spending a lot of time and energy strategizing ways to beat the tax. Remember, AMT was created specifically to close loopholes, so in the majority of cases there is not much you can do about it.
A final note: This discussion of AMT is a cursory overview. The rules around this tax are extremely complex, and we encourage you to speak with your financial advisor if you’d like to understand it better.
Bijan Golkar is a Certified Financial Planner™ and licensed tax preparer with FPC Investment Advisory Inc. in the San Francisco Bay Area.