In 1969, Treasury Secretary Joseph Barr announced that 155 high-income households hadn't paid any taxes at all that year. The obvious public outcry prompted Congress to institute an add-on tax they called the alternative minimum tax (AMT), taking effect the next year. As part of the 1982 tax reforms under Reagan, it was changed from an add-on tax to an alternative tax system, but the goal of ensuring that high-income individuals and corporations had to pay some taxes remained. Unfortunately, there was a huge flaw in the system- the exemption amount was never indexed to inflation. As a result of this, the tax affects more and more Americans each year. In fact, some estimates are that more than 15% of people making $75-100K a year have to pay AMT. Obviously, many doctors and professionals with similar incomes get snagged by this tax each year.
When Do You Have To Pay AMT Tax?
The Alternative Tax System (AMT) is a complete tax system, run in parallel to the regular one you're probably more familiar with. Each year, you technically have to compute your taxes under both systems, then pay whichever is higher. It generally hits those with an income between $115K and $415K the hardest, which is a large percentage of docs. The AMT is actually quite a bit simpler than the regular tax code. There is only one exemption amount- $74,450 married ($48,450 single), and only two brackets, 26% up to $175K then 28% above that. There are no personal exemptions or standard deductions. The exemption phases out between $150K and $447,800K ($112,500-306,300 single). Some of the common deductions used in the regular tax system are disallowed under the AMT.
Who Pays Alternative Minimum Tax?
Three groups of people make out poorly under the AMT, and the more of these groups you belong to the more likely you are to have to pay additional tax because of it. 1) People who pay high state and local income taxes. Unlike many deductions which are the same (or even better due to the higher marginal rates), state and local income taxes aren't deductible under the AMT. Thus, those who pay them are more likely to have to pay under the AMT system. 2) People with lots of kids. “Finally!” say those DINKs. But since there are no personal exemptions for those with 12 kids, their tax burden under AMT is likely to be higher than under the regular system. 3) People who live in high cost of living areas. Not only are many high cost of living areas (such as California and NYC) also high state/local tax areas, but they have the unfortunate effect of higher salaries to go with the higher cost of living. The higher salary triggers the AMT.
Do I Have to Pay Alternative Minimum Tax?
How do you know if you'll have to pay alternative minimum tax? The single best way is to use tax software. It'll compute it automatically. If you need to know before you do your taxes in the Spring, then you'll need to estimate your taxes. If you're too cheap to fork out for Turbotax, you can just spend a few hours with Form 6251. Don't forget the 12 pages of instructions.
How to Avoid AMT
If you find you're getting hit with the AMT each year, and would prefer not to, then what you need to do is increase your deductions that actually count under the AMT. The best one of these is your retirement accounts. Each dollar stuffed into a 401K, profit-sharing plan, SEP-IRA, or defined benefit plan is a dollar off your taxable income under both systems. To make things better, you get to keep that dollar, at least until you lose (hopefully a tiny) part of it to taxes upon withdrawal a few decades from now. The worst one is to disown your kids. This doesn't actually affect the amount you owe under AMT, but it will increase the amount owed under the regular tax code, so you can pay that instead of AMT. You can also move out of Manhattan or California. Given recent referendum results in California and recent weather results in Manhattan, that's probably a good idea anyway. This is again smoke and mirrors though, since it will just increase your federal income tax so you won't pay the AMT instead, although the decrease in state and local taxes (not to mention cost of living) will probably more than make up for it. If, for some reason, it's municipal bond interest that's pushing you into the AMT, you might want to consider that when trying to determine your most tax-efficient asset allocation for your portfolio. You can also buy a bigger house (or do a money-out refinance) so you're paying more mortgage interest or give more money to charity. These deductions can actually be more valuable for someone paying AMT than someone who isn't. It can also be helpful to stay out of the $150K-415K income range. Perhaps you should realize a million dollar capital gain all in one year rather than spread it out. Part-time work may also become more attractive to you. In the end, there isn't a lot you can do about AMT.
Good News About The AMT
Everyone in both political parties knows this system sucks and is a huge flaw and they constantly discuss fixing it. They are hesitant to do so, however, because it brings in a lot of money (~$100 Billion a year, or about 4% of total federal income tax revenue) and fixing it would mean either spending less or raising another tax, which would just piss someone else off. Since 3/4 of the people paying AMT are making more than $200K, any modification would be politically construed as a tax break for the rich. As long as we're talking politics, part of this IS George Bush's fault. The Bush tax cuts cut everyone's tax rates, but only under the regular system, not the AMT. I suppose if we go over the “fiscal cliff” now being discussed in Washington then there will be a lot fewer people paying AMT (because they're paying more under the regular system.)
There is one nice thing about the AMT. The extra amount paid if you're caught by the AMT can be applied as a credit to your regular taxes in future years, although I understand this generally doesn't apply to “exclusion items” like state taxes and exemptions for lots of kids, which I suspect is what trips up most doctors who are paying AMT.
Do you pay AMT? What have you done to avoid it?