There are few things in the world of taxes more terrifying than the Alternative Minimum Tax (AMT).
After taking all of that time with your W-2s, donations, and various deductions the AMT steps in and tells you that none of that matters; you suddenly owe thousands more in tax.
That’s scary enough for me. Here’s an overview of the Alternative Minimum Tax and what can trigger it to impact your taxes.
What is the Alternative Minimum Tax (AMT)?
Did you know there are two versions of income tax in the United States?
You have your typical income tax that you have been paying your whole life. You show all of your income, you take deductions and credits, and you get a tax refund or a tax bill based on how much tax was withheld from your paychecks throughout the year.
The second version of the income tax was originally implemented to target a very specific section of tax payers.
Congress passed the Tax Reform Act of 1969 in order to prevent super wealthy individuals from taking special tax benefits and deductions to pay an unfairly low amount of tax.
Congress updated the legislation in 1986 with an amendment that caught an even higher number of households in the AMT’s grasp. Now families that were in the upper middle class rather than just the wealthiest were paying the alternative minimum tax.
What Causes the AMT to Impact a Tax Payer?
The problem with confusing legislation is there are no clear guidelines as to what specifically causes the AMT. You can’t read a guide as to what to do or not to do in order to avoid the AMT affecting your tax situation.
What we do know is that there are certain items that increase your odds of being hit with the AMT:
Common items you might find on any tax return:
- State and local tax deductions (property tax, sales tax, and income tax)
- Personal exemptions
- Taking the standard deduction
- Having large amounts of deductions (medical expense deductions, miscellaneous deductions, etc.)
- Tax credits (the more you claim, the more likely you will be hit by the AMT)
Uncommon items you may not have on your return:
- Interest on a second mortgage
- Incentive stock options
- Tax shelters
- Long term capital gains (you may have these occasionally, but unlikely to have huge gains every year on your tax return)
- Tax exempt interest on certain types of bonds
How Does the Alternative Minimum Tax Change Your Taxes?
The easy answer is unpleasant: you will pay more in taxes to the government.
To calculate what you would owe the government if the AMT hit you, you need to recalculate your taxes specifically for the alternative minimum tax.
The Internal Revenue Service has an AMT calculator to walk you through the steps.
The calculation removes some or all of tax credits and deductions you were able to take during the year. You get to use an AMT exemption instead which is set by legislation. You are then taxed at either 26% or 28% at the higher levels. (Compared to 10% to 35% for normal income tax rate ranges.)
If your calculation shows that your AMT tax is higher than your normal income tax, you fall under the AMT guidelines. Otherwise, you are not under those guidelines and file your income taxes normally.
For example, if your normal income tax shows you owe the government $40,000. Your AMT calculations show you owe $35,000. Since your AMT tax is less than normal income tax, you are not impacted by AMT and pay normal income tax.
On the other hand, if your normal income tax shows you owe $40,000, and AMT shows you owe $48,000 you fall under AMT. You would then pay the government $40,000 in your normal income taxes plus $8,000 in alternative minimum tax.
Congress Passes Alternative Minimum Tax Bandaids
For a piece of legislation originally targeted at extremely wealthy individuals that were using tax tricks to avoid paying tax, why are so many middle-class families being hit with AMT?
When the legislation was passed and then amended, the income levels that fell under AMT were not indexed to inflation. So an income level that was once in the 1% of the 1% has, over time, become more commonplace as incomes and inflation grow.
The rules of the legislation have that income level written in stone rather than going up each year based on inflation, so as that income becomes more common more taxpayers fall under the set in stone limit.
Congress has passed some temporary fixes for middle class families over the years, but each year it costs the government billions of dollars. As the national debt continues to grow it is going to become politically impossible to skip out on that additional tax revenue. The only true fix is for Congress to go back and calculate what the actual limit should be based on inflation, change it to that, and then index that number to inflation.
Update – With its signing into law the Taxpayer Relief Act of 2013 permanently ties the AMT to inflation, so there is no longer a need for Congress to pass “patches.”