Do you know if you are likely to be subject to the alternative minimum tax (AMT) — and what actions can trigger it? If not, you need to find out so that you can consider taking steps to address potential AMT liability.
The AMT was established to ensure that high-net-worth individuals pay at least a minimum tax, even if they have many deductions that reduce their “regular” income tax. If your AMT liability is greater than your regular income tax liability, you must pay the difference as AMT, in addition to the regular tax.
AMT rates begin at 26% and rise to 28% at higher income levels. The maximum rate is lower than the maximum income tax rate of 39.6%, but far fewer deductions are allowed, so the AMT could end up taking a bigger tax bite.
For example, you cannot deduct state and local taxes, property taxes or home equity loan interest on loans not used for home improvements. You also cannot claim the standard deduction or take personal exemptions for yourself or your dependents.
Those with high incomes are more susceptible to the AMT than others, but AMT liability may also be triggered by:
- A large family (meaning you take many exemptions);
- Substantial itemized deductions for state and local taxes, home equity loan interest, medical expenses, or similar expenditures;
- Exercising and holding incentive stock options;
- Large capital gains;
- Adjustments to passive income or losses or
- Interest income from private activity municipal bonds.
Knowing some of the risk factors can make it easier to reduce or avoid AMT liability.
Strategies to Minimize Liability
Fortunately, you may be able to take steps to minimize your AMT liability, including:
Timing Capital Gains
The AMT exemption (the amount you can deduct before calculating AMT liability) phases out based on income, so realizing capital gains could cause you to lose part or all of the exemption. Moreover, the AMT has fewer deductions to offset a large gain. You may want to delay sales of highly appreciated assets until the next year (when you won’t be subject to the AMT) or use an installment sale to spread the gains (and potential AMT liability) over multiple years.
Timing Deductible Expenses
Try to time the payment of state and local taxes and other miscellaneous itemized deductions for years that you do not expect the AMT to apply. Otherwise, those deductions will go unused. If you are on the threshold of AMT liability this year, you may want to consider delaying state tax payments if the late penalty does not exceed the tax savings from staying under the AMT threshold.
Investing in the “Right” Bonds
Interest on tax-exempt bonds issued for public activities (for example, schools and roads) is exempt from the AMT. You may want to convert bonds issued for private activities (for example, sports stadiums), which do not enjoy the interest exemption. Or, if you are subject to the top income tax rate of 39.6%, invest in taxable bonds that will nonetheless result in a higher rate of after-tax return, taking into account the lower AMT rate.
Do Not Put Your Head in the Sand
Failing to pay the AMT can lead to penalties and interest, so it is best to determine ahead of time whether it will apply.
If you need assistance assessing your risk and implementing appropriate strategies to reduce the odds of liability and the liability itself, contact Dan Newman at [email protected] or call him at 312.670.7444. Visit orba.com to learn more about or Wealth Management Group.