Understanding The Alternative Minimum Tax

By:    Updated: March 10,2017

There is nothing worse than finding out that you have to pay more taxes. However, if you take advantage of certain kinds of tax exemptions and deductions, you may be subject to the alternative minimum tax which will effectively increase your annual tax payment to Uncle Sam. But what is the alternative minimum tax and how can you find out if you will have to pay it? This article will walk you through everything you need to know about the alternative minimum tax.

What Is The Alternative Minimum Tax?

The Alternative Minimum Tax (AMT) is a tax that was created by Congress to make sure that wealthy individuals and people with creative accountants paid their fair share of federal income taxes. Before, the creation of the AMT, some people with strong tax code prowess were taking advantage of certain tax exemptions and deductions in order to substantially reduce the amount of federal income taxes that they paid. The AMT was created in order to remedy this phenomenon.

How The AMT Works

The AMT functions just like the federal income tax system. It has its own forms, rules and tax brackets. However, the rules of the AMT were created specifically to erase many of the tax loopholes found in the standard federal tax code. If you are subject to the AMT, you may have to fill out and file a separate set of tax returns. This is in addition to filling out the standard federal tax forms. In the process of filling out both returns, you will calculate your federal income tax under both systems. After you have calculated the amount of taxes that you must pay under both tax systems, you will be required to pay the higher tax bill. Since the AMT system was created to close tax loopholes in the standard system, the tax bill associated with it will likely be higher than the standard federal tax bill.

Who Might Have To Pay The AMT

There is an income exemption associated with the AMT. This means that if your income falls under a certain amount, you will not be subject to it. The exemption amounts tend to increase every year.

However, if your income is above these levels, you might find yourself subject to the AMT if

  • You made substantial deductions for your state income taxes.
  • You made substantial deductions for dependent exemptions. This could apply to you if you have a lot of children.
  • You made substantial deductions for interest on a home equity loan that is used for purposes other than home improvements.
  • You earned substantial investment income from certain municipal bonds.
  • You exercised "deep in the money" incentive stock options.

However, since there is no test for the AMT, if you made any large deductions on your federal income taxes, it might be a wise decision to ask a professional if you could be subject to the AMT. Don't assume that the AMT only applies to wealthy individuals and tax experts.

How To Avoid Or Reduce Your Exposure To The AMT

Although the AMT was created to be difficult to get out of, there are a few things you can do to reduce or eliminate your exposure to it.

  • Reduce Or Eliminate Your Investments In Municipal Private Activity Bonds: Most municipal bonds are exempt from both federal income taxes and the AMT. However, the interest from municipal bonds that are used to fund private activities such as sports arenas, hospitals and housing projects (to name a few) are fully taxable under AMT. You can reduce your exposure to AMT by reducing or eliminating your investments in these types of bonds. Keep in mind that your interest dividends from bond funds or mutual funds that hold private activity bonds will also be subject to the AMT.
  • Don't Take Out A Home Equity Loan For Anything Other Than Home Improvements: The AMT will not allow you to deduct any interest on the loan unless the loan proceeds are used for home improvements. Avoid using your home equity line for non-home improvement purposes.
  • Decrease Your AMT Taxable Income For The Year: It might sound counterintuitive, but finding ways to slash your income that could be taxed under the AMT will help you reduce your exposure to the AMT. Consider deferring a year-end bonus into the next year. If you have some poorly performing investments, sell those at a loss to reduce your taxable income. You may want to consult a tax adviser for others ways to decrease your chances of being subject to the AMT.

More and more people are finding themselves victims of the alternative minimum tax. If you think you might be subject to the AMT this year, the best thing that you can do is to plan ahead. Speak with a tax planner about how to lessen or eliminate your exposure to it. This will help to save you grief and, if you're lucky, money.

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