Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)
Part VII. Other Important Things to Know
Beyond the taxation of income, deductions, and credits, there are a few more important things that you should know. First, the Alternative Minimum Tax is always lurking in the shadows of your tax world. Be sure to know how it works and whether you are in danger of its wrath.
Second, be sure to understand the penalties and interest the IRS can hit you with, and how to avoid them. Third, it is important to know when to get help. There are times when professional advice can make a very big difference. And last, the Affordable Care Act reaches into nearly every aspect of your tax return. Be sure to understand how it will affect your return. Part VII has a chapter devoted to each of these topics, which you won’t want to miss.
Chapter 31. The Alternative Minimum Tax
Let the Fear and Trembling Begin
Every year more people are becoming aware of the existence of the Alternative Minimum Tax (AMT). Some of this awareness is the result of the media’s focus on it. Unfortunately, though, many people become aware of this tax only because it has shown up on their tax return unexpectedly. Every year more middle-income Americans find themselves caught by the AMT, and it is painful when it catches you.
The AMT is like that kid in school who said he would share his candy with you if you did something for him and then, after you did it, he just laughed as he ran away. In the same way, the AMT reneges on the promise that certain deductions will reduce your taxes. After you sacrifice and plan for all of the tax-reduction strategies available to you and triumphantly get to the line on your tax return that shows your lowered tax liability, the AMT comes in and tells you that your tax is not high enough and takes away some of your deductions to increase your tax. Are you angry yet?
The AMT was first levied in 1970. It was originally designed to target 155 ultra-high-income households that had little to no tax liability because of how they had structured their deductions. The tax has been modified several times over the last four decades, but the income thresholds that trigger the tax have not been indexed for inflation. As a result, millions of not-so-high-income households are now affected by the tax. If it were not for the one-year patches that Congress enacts each year, many millions more would be affected.
Example Spencer is a single man who works on a road crew for a living. He makes $23 per hour, or about $48,000 per year. Even though his income is far from “high,” he is subject to the AMT.
The AMT was originally designed to make wealthy individuals who had found a way to pay no income tax begin to pay their “fair share.” It is a complicated system of taxation that has its own separate formula, independent of the normal income tax calculation.
Many of the itemized deductions allowed in the calculation of regular income tax are eliminated in the AMT calculations. State income taxes, sales tax, and real-estate taxes are not deductible. Interest on loans for boats or RVs, as well as some home equity interest, is not deductible. All miscellaneous itemized deductions subject to the 2% Adjusted Gross Income (AGI) floor are taken away for the AMT as well. The medical-expense limitation is increased to 10% of AGI instead of 7.5%. Income from certain municipal bonds that is not taxed in the regular tax is added back for the AMT. And so it goes down the line. In short, many of the things that taxpayers rely on to reduce their tax liability are omitted in the calculation of the AMT.
If you use the standard deduction, you will need to be concerned with the AMT if you are single and have an AGI above $52,800, or if you are married and have an AGI over $82,100 in 2014. After many years of annual bickering over these thresholds, Congress has finally indexed them to increase every year, based on inflation. If you itemize your deductions, you will be affected by the AMT if your AGI, minus the allowable AMT itemized deductions, is above the previously listed numbers. As you can see, these AGI numbers apply to many who are not exactly “high-income” taxpayers.
The tax is a flat tax of 26% or 28%, depending on your income. If the calculation of the AMT turns out to be higher than the calculation of your regular income tax, you will owe the higher amount. To make matters worse, some tax credits can’t offset the AMT—compounding the difference between the AMT and the regular tax.
If your AGI will subject you to the AMT, you should consider several things in your tax planning. First, ensure that any “tax-free” municipal bond or bond fund that you purchase includes no “special activity” bonds. The interest from those bonds will be included in the AMT calculation—meaning that these “tax-free bonds” will not be tax-free. The investment company you use to buy the bonds can tell you whether the individual bonds, or those held in your bond fund, are AMT-free.
The second thing you should be aware of in your tax planning is that the very deductions you claim when itemizing deductions on Schedule A (such as state taxes) may be what trigger the AMT. Shifting where you claim these deductions, or when you incur the expenses, can affect the amount of AMT you will owe.
Third, be aware of the deductions that are allowed under the AMT. Home mortgage interest and charitable-giving deductions are fully allowed against the AMT. Above-the-line deductions are also allowed and will reduce this tax. Focus on increasing deductions that minimize the AMT and reducing those that don’t, and you may find that you have a better result in the end.
Here are some specific strategies to reduce your AMT:
· Pay medical expenses on a pretax basis. You can do this by using a medical reimbursement plan, Health Reimbursement Arrangement (HRA), or Flexible Spending Account (FSA). You can also do this by contributing to a Health Savings Account (HSA), as discussed inChapter 26. In this way you can deduct medical expenses that are less than the 10%-of-AGI floor that the AMT requires. You can also thus reduce your AGI, thereby reducing your tax.
· Ask your employer to set up an “accountable” employee expense reimbursement plan. The “unreimbursed employee expenses” deduction is not allowed under the AMT. Even if your employer is unwilling to reimburse those expenses, see if the company will reduce your income by that amount and then reimburse you. In this way the employer will save money in employment taxes, and you will save money in employment taxes, income taxes, and AMT taxes.
· In certain situations you should take the standard deduction instead of itemizing, even when the itemized deductions are larger. This is because some of those deductions are eliminated when the AMT is calculated. Run the numbers both ways to see which brings the better result.
· Take as many business-expense deductions as you legitimately can. They are fully deductible this way, and with them you avoid losing the deductions under the AMT. You could do this, for example, by deducting a portion of your real-estate tax as an expense when you claim a business use of your home.
· Minimize any overpayment of state taxes. If you paid additional state taxes in order to reduce your federal tax and then receive a state refund on the extra, this strategy will backfire if you are subject to the AMT.
· The preferred tax rates on capital gains and qualified dividends are not changed by the AMT calculations. These sources of income become even more beneficial in the context of the AMT. Increasing these sources of income and reducing others will reduce your AMT.
· Time your income and expenses with the AMT in mind. This can prove very helpful if you’re at risk of being subject to the AMT. If you can postpone income and accelerate specific deductions in a particular year, you could avoid the AMT in that year, and even if you end up paying the AMT in the next year, the net effect over two years may be better.
The AMT is a very complicated tax. It has so many moving parts and variables that it is hard to fully understand even for many tax professionals, much less other people who don’t devote their life’s work to taxes. The thorns are so numerous that I cannot fully list them here. If you are at risk of being significantly affected by the AMT, I highly recommend professional advice.