A Guide to the Alternative Minimum Tax

These days, more and more tax payers who owe US Federal income tax are finding themselves subject to the dreaded Alternative Minimum Tax (AMT) that previously only the ultra-wealthy had to worry about. To make matters worse, the guidelines available to help you know whether or not you'll need to pay this tax are fuzzy to say the least. The good news, though, is that if you're willing to put in the effort there are a few things you can do to protect your hard earned cash despite owing the AMT.

What is the Alternative Minimum Tax?

The AMT is another way of calculating how much federal tax you owe. With the usual way, you calculate your adjusted gross income (AGI), then subtract your standard deduction or itemized deductions and your personal exemptions. That gives you your taxable income.

With the AMT, you also start with your AGI, but then you can subtract only those relatively few deductions and exemptions allowed under AMT guidelines. Since AMT rules allow fewer deductions, you end up with a higher taxable income. Not only that, but that income is then subject to a flat tax rate of 26% (or 28% if your taxable income is over $175,000 or $87,500 if married but filing separately) (see: IRS Form 6251.)

Naturally, because the AMT doesn't let you take the standard deduction, personal exemptions, or some itemized deductions, you're almost certain to end up owning more through this method of calculating your taxes than through the standard method. In fact, that's the whole point of this tax.

Who has to pay the Alternative Minimum Tax?

The alternative minimum tax was originally created to prevent high income households from claiming so many special deductions that they ended up paying little or no income tax. The problem is that this tax isn't indexed for inflation, so each year more and more tax brackets fall into the AMT category. It's rapidly sneaking up on the middle class, including those who don't claim a lot of special tax deductions.

So how do you know if you need to pay the Alternative Minimum Tax? Unfortunately, like a lot of taxation issues, this one's not so clear. Suffice it to say, if you have an income over $46,000, you'll want to look into your AMT liability.

Other things that can trigger the AMT are large personal and standard exemptions (yes, really), deductions for state and local taxes, deductions for medical expenses or mortgage payments, tax-exempt interest, and large capital gains. If you own a business or you're self-employed (especially if you'll be taking a net operating loss deduction or claiming business-related tax credits), you'll also want to calculate your ATM.

Besides these, there's one thing almost always triggers AMT liability: exercising incentive stock options. If this applies to you, talk with a financial advisor about how it will affect your AMT payment.

Having to recalculate your taxes may not be fun, but it's far better to do this yourself and find out for sure than to let the IRS do it and end up with a bill for interest and penalties or even trigger an audit. To find out for yourself, go to the IRS Web site at www.irs.gov, download Form 6251, "Alternative Minimum Tax - Individuals," work through the form and see how much you owe.

What can you do to ease the sting?

First of all, keep in mind that even if you're subject to the Alternative Minimum Tax, you can still claim a special AMT exemption. If you're filing for 2008, that will be $46,200 for single filers, $69,950 for joint filers, and $34,974 if married, but filing separately (see: IRS Form 6251).

Beyond this, you have two options to lower your taxes: speed up your income or defer your deductions. To effectively hurry your income along, you can redeem CDs and savings bonds, withdraw cash from your retirement fund, or request an advance on your salary or bonuses. If those choices don't sound too appealing, an easier method to save money in the face of AMT liability is to hold off payment of non-AMT deductible expenses until a year when you won't be subject to the AMT (and you can actually apply those deductions). That might mean deferring payment of state or local taxes if possible, interest on large loans, and medical expenses.

Don't think just because you're not "rich" you can ignore the Alternative Minimum Tax. These days, an increasing number of middle class folks with average salaries are finding themselves subject to this higher tax rate. To find out for sure if you're one of them, either talk with your financial advisor or download IRS Form 6251 and see for yourself.