About 4 million taxpayers each year get hit with the alternative minimum tax (AMT). While some efforts have been made to modify the tax code, the AMT continues to be part of the system. Still, there are strategies the investors can use to try to mitigate or avoid the AMT.
Millions still pay AMT despite rule change
Congress introduced AMT in 1969 to ensure that wealthy individuals could not avoid income tax by exploiting weaknesses in the tax code. When first implemented, the AMT only affected high earners. But, until recently, AMT rules were not indexed for inflation. Over the past 40 years, economic growth and inflation have caused wage levels to increase significantly, yet the income threshold above which individuals must figure their AMT liability stayed level, resulting in an expansion of the AMT.
Even now that the rule is indexed for inflation, millions of Americans still pay AMT. AMT typically affects taxpayers with higher income and more dependents, as well as those whose property and state income taxes are higher. The AMT system does not allow taxpayers to benefit from personal exemptions or many popular tax deductions such as local property taxes and state income taxes.
Strategies to avoid AMT
There are several planning strategies investors may consider to try to avoid reaching a level of income that would trigger AMT.
- Be careful with timing of income. Transactions involving a particularly large capital gain or Roth IRA conversion, for example, may increase AMT exposure.
- Take care when executing certain stock options. Exercising incentive stock options (ISOs) is typically a triggering item. Under AMT rules, taxpayers must recognize as income the “spread” between the market price and the exercise price of the options.
- Reduce income. For some taxpayers, tax-smart strategies, such as taking advantage of pre tax contributions within an employer retirement plan, may help to avoid being subject to AMT.
For investors who are certain they will be subject to the AMT, here are some action items to consider:
- Defer certain deductions. The tax advantage of certain deductions will be lost if claimed in a year when you will owe the AMT. In this case, consider delaying certain deductible expenses until the following tax year if possible, in the event you are not subject to AMT. Common examples of expenses that can be moved into the next tax year include local property taxes and state income taxes.
- Evaluate a Roth IRA conversion. For those subject to AMT, there are only two marginal tax rates (26%, or 28% if income exceeds $187,800). Some taxpayers who typically may be in higher marginal tax brackets under the regular income tax system may want to consider accelerating income. One method to accelerate income is by converting traditional IRA assets to a Roth IRA. But before accelerating income, taxpayers should consider the Medicare net investment income surtax of 3.8%, which begins at income levels above $200,000 for individuals and $250,000 for couples (based on modified adjusted gross income).
- Avoid private activity bonds. The interest income from most private activity municipal bonds is taxable under AMT rules.
The future of AMT remains uncertain as various federal tax reform plans have called for its elimination. The fiscal reality, however, is that AMT provides approximately $35 billion in revenue for the federal government. Before a change is approved, lawmakers would probably need to replace this revenue as part of any tax reform plan that is revenue neutral.
AMT is complex. In order to try to mitigate or avoid AMT, it is important to discuss strategies with a qualified tax professional to understand the income thresholds and triggers. To learn more about AMT and tax-saving strategies, read Putnam’s education article, "The alternative minimum tax."
For informational purposes only. Not an investment recommendation.
This information is not meant as tax or legal advice. Please consult with the appropriate tax or legal professional regarding your particular circumstances before making any investment decisions. Putnam does not provide tax or legal advice.