What is the Alternative Minimum Tax?
An alternative minimum tax (AMT) is the minimum amount of tax that high earners must pay on their income. It is paid in addition to ordinary income tax. AMT taxes income above IRS-specified limits. The AMT exemption limit for 2020 is $113,400 for married couples filing jointly and $72,900 for singles. For 2021, it is $73,600 for singles and $114,600 for married couples, filing jointly. Depending on the income liable for taxation, alternative minimum taxes are applied at 26% and 28%. AMT exemptions are phased out at $523,600 for single filers and at $1,047,200 for married couples, filing jointly. Therefore, filers above these amounts do not receive exemptions. You can find out if you owe AMT by using IRS Form 6251.
Basics of Alternative Minimum Taxes
The AMT was originally conceived as an “add-on” tax in 1969 to prevent abuse of the tax code by the rich. It was minimum tax applicable to certain line items on the tax sheet, such as capital gains resulting from the sale of an asset. The AMT, in its current form, came into being in 1979 as the numbers of the wealthy grew in the country. The add-on tax was repealed in 1983.
There are two important differences between the calculations for an AMT and regular income tax. The first one is the presence of an AMT exemption limit. While everyone is required to file regular income tax, the AMT was meant to ensure that the very wealthy pay their tax dues. The AMT exemption limit is a means to exclude the lower income and middle class from being penalized. Over the years, AMT exemption limits have trended higher due to an increase in inflation numbers. Most recently, the Tax Cuts and Jobs Act (TCJA) of 2017 raised exemption limits and phase out thresholds.
As a result of this change, the number of people paying AMT has also declined. At the same time, credits have been introduced to enable reduction of overall tax amounts. For example, if you’ve paid AMT in a previous year and are not paying it this year, then you are eligible for an AMT tax credit applicable on the tax preference items.
The second difference lies in the treatment of deductions and gains. AMT adds back tax preference items or items that are excluded while calculating regular income tax. An example is asset depreciation that can provide tax deductions to reduce overall liability in regular income tax calculations but triggers an AMT and must be added back to the total after the regular tax is calculated (see below).
How to Calculate AMT
The process to calculate AMT begins with a calculation of the regular income tax. The next step is to add back AMT-related preferential tax items to the previous total. Examples of tax preference items are investment tax credits, dividend payments, and capital gains. State and local taxes must also be added back in AMT calculations. So must interest earned from Private Activity Bonds (PAB), a type of state or local bond that is usually considered tax-exempt, and income derived from exercising of stock options. The addition of these tax items gives you a minimum alternative income tax amount accruing to the individual.
From this total, you should subtract the AMT exemption limit and personal credits (if applicable) for tax preference items on AMT paid in the previous year. For example, if the calculated total from the previous step is $300,000, then you must deduct $73,600 (based on 2021 AMT exemption limits) from $300,000.
Depending on the total income amount that is obtained after this calculation, the final figure is calculated by multiplying it with either 26% or 28%. For example, income below $197,900 was taxed at a 26 percent rate while income above that amount was taxed at 28 percent in 2020. In the example above, the income amount is $226,400 after subtracting the AMT exemption. Therefore, the tax liability works out to $63,392. Compare this figure with the figure for calculated regular income tax. The individual’s tax liability is the higher figure of either amount.
If the calculations above sound like a slog, then you can use available tax software in the market that will do the heavy lifting for you. All you need to do in such software is to enter the relevant amounts for income and deductions and it will calculate the applicable tax amounts.
Strategies to Minimize AMT
There are several steps that you can take to minimize or, even, eliminate alternate minimum tax. Some of them are outlined below.
- Maximizing contributions to retirement accounts: Most retirement accounts defer taxes to until after retirement, when taxes are calculated as regular income tax. If you maximize contributions to your 401(k), 403(b), and IRA accounts, then you will have less income to report for taxes and, therefore, less tax liability.
- Charitable Donations: Charitable donations are tax-free, meaning you do not have pay taxes on the amount that you donate to charity. Making donations to a foundation or your favorite charity can also reduce your overall taxable income and, potentially, move you out of the AMT range.
- Increase business expenses: You can claim exemptions by spending on business items and infrastructure. The effect of this strategy would be to move them to a different schedule (Schedule C) and reduce the amount of income that is liable to be taxed.
- Use tax credits: AMT offers several credits, such as dependent care credit and foreign tax credit, that can be used to reduce the overall tax liability. These credits are applied along with the exemption limit after the tax-preference items are added.
Criticism of AMT
The AMT was supposed to penalize rich folk who devised strategies to avoid paying taxes. But it disproportionately targets the upper middle class, whose income ranges between $200,000 to $1 million. Over the years, fewer households with income over $1 million pay taxes while the AMT dragnet has succeeded in catching more of those whose income is less than $1 million. According to simulations by the Urban-Brookings Tax Policy center, before the TCJA was passed in 2017, 63.8% of the total number of households that paid AMT had incomes between $500,000 to $1 million. 23.3% had income between $200,000 and $500,000 and only 24.2% of households had income above $1 million. This disparity is due to several reasons. For example, the addition of personal credits to the overall total can penalize big families. People who live in high tax states also receive the short end of the stick because state and local taxes are added back to AMT calculations. On the other hand, the very rich – the people who the tax is meant to discipline – can shift residences and businesses to lower tax jurisdictions and escape tax liabilities.