Tax Connections Newsletter – Spring 2012
Frank L. Washelesky

The Alternative Minimum Tax Trap

When the alternative minimum tax (AMT) system was introduced in the early 1980s, it was intended to prevent a small number of taxpayers with substantial economic income from completely avoiding federal income taxes through the use of exclusions, deductions and credits. The idea was to have those taxpayers do a secondary tax computation and then pay the higher of their “regular tax” or the tax determined under the AMT computation.

A Wider Reach

Today, the secondary tax computation concept remains largely in place. But the AMT’s tentacles have reached far beyond the small group targeted by the original AMT legislation. Every year, millions of taxpayers who don’t consider their tax situations at all unusual are surprised to find they owe the AMT.

One reason: AMT exemptions are not inflation-indexed. Unless Congress raises them, as it has done in the past, the 2012 exemptions are:

  • $33,750 (unmarried)
  • $45,000 (married filing jointly)
  • $22,500 (married filing separately)

Not everyone receives the benefit of an AMT exemption because the exemption is phased out for taxpayers whose AMT income exceeds a threshold amount. AMT income is basically taxable income recalculated by taking mandated preferences and adjustments into account.

Among the taxpayers most likely to be affected by the AMT are individuals who live in high-tax areas, exercise company stock options or have many dependents. Why? Deductions for dependency exemptions and state and local income and property taxes generally are not allowed for AMT purposes. And taxpayers who exercise incentive stock options generally must include the spread between the stock’s fair market value on the exercise date and the exercise price in AMT income (but not in regular taxable income).

Reducing Your Exposure

If a tax projection indicates you could be subject to AMT in 2012, you may be able to take steps to reduce your exposure. For example, you might avoid prepaying property taxes or state and local income taxes. Or, if you invest in municipal bond funds, you might consider switching to funds that specifically generate AMT-exempt income. These funds sidestep investments in most private activity municipal bonds, since they pay interest that’s includable in AMT income.

Of course, you won’t want to make tax decisions without considering the effect on your overall financial strategies. We can help you review your specific circumstances and recommend appropriate actions if AMT is a concern.

New Tax on Investment Income

A new 3.8% Medicare tax on the “unearned” (investment) income of higher-income individuals will take effect in 2013. It’s not too soon to look at potential strategies for minimizing the tax if you’re likely to be subject to it.

Who Will It Affect?

The new tax will be imposed on taxpayers who have any amount of net investment income and modified adjusted gross income (AGI) that is greater than:

  • $200,000 (single; head of household)
  • $250,000 (married filing jointly)
  • $125,000 (married filing separately)

The tax is computed by multiplying the 3.8% tax rate by the lesser of (1) net investment income or (2) the excess of modified AGI over the threshold for your filing status.

Example. Gary, a single taxpayer, has $40,000 of net investment income and total modified AGI of $260,000 in 2013. His tax will be 3.8% of $40,000, since $40,000 is less than $60,000 ($260,000 modified AGI minus $200,000 threshold for a single filer). If Gary’s modified AGI instead totals $199,999 — and it includes the same $40,000 of investment income — he won’t owe the 3.8% tax.

What’s Included in Investment Income?

Taxable interest, dividends, rents, royalties, annuities and capital gains are all considered to be investment income. So is income from a business investment if you don’t “materially participate” in the business.

Various planning strategies may be appropriate if the 3.8% Medicare tax is a potential concern. Consult with us to discuss possible strategies.

Saving for Retirement When You’re Self-employed

You’re in good company if retirement security is one of your main financial concerns. A difficult economy, market volatility and less access to traditional pensions have heightened awareness of the need for retirement planning. As a self-employed individual, you really have to think carefully about your future, since you don’t have an employer-sponsored retirement plan to help you prepare.

But you do have options. Several tax-favored retirement plans are available to self-employed individuals. All allow you to make tax-deductible contributions. And those contributions, along with investment earnings, grow tax deferred until you take withdrawals from the plan. Here are three options you may want to consider.

SEP Plan

A Simplified Employee Pension (SEP) plan is relatively easy and inexpensive to set up and administer. It allows you to contribute up to 25% of as much as $250,000 of compensation annually, subject to a maximum contribution limit of $50,000 per person for 2012. (There is a special computation for figuring your maximum deduction for contributions to your own SEP account.) Within these parameters, you have the discretion to determine how much money, if any, you want to contribute each year.

On the downside, a SEP is entirely employer-funded. If you have eligible employees, you must contribute the same percentage of compensation for them as you do for yourself or use another allocation formula that does not discriminate in favor of highly compensated employees. Also, since a SEP uses individual retirement accounts, loans are prohibited.

Solo (Individual) 401(k)

A solo 401(k) plan may be a suitable option if you work alone or employ only your spouse. For 2012, this plan allows you to defer the first $17,000 of your compensation (or $22,500 if you’re age 50 or older). You also may make a profit sharing contribution (subject to tax law limits). The combination of all contributions — including deferrals, profit sharing and any others — may not exceed the lesser of (1) 100% of your compensation or (2) $50,000 ($55,500 if you’re age 50 or older). As with a SEP, contributions are discretionary.

If you foresee wanting to borrow from your account, a solo 401(k) may be preferable to a SEP, since loans are allowed (within certain tax law limits). Another potential advantage is that a 401(k) plan can be set up to accept after-tax Roth contributions. Unlike with a standard 401(k), amounts in a Roth 401(k) account may be withdrawn from the plan tax free once you’ve met specified conditions.


Like a SEP, a SIMPLE IRA plan is structured with IRAs for yourself and each participating employee. You and your employees can elect to defer compensation to the plan (no more than $11,500 in 2012; $14,000 if age 50 or older). An additional employer contribution is required annually. Employers can either: (1) match employee contributions up to 3% of pay (a lower 1% match is allowed in certain years) or (2) contribute 2% of pay for each employee who’s eligible to contribute, even if the employee chooses not to contribute.

This plan is designed to be simple to administer, but contribution limits are relatively low and you must be prepared to commit to making annual employer contributions. Loans are not allowed. A SIMPLE IRA generally isn’t an option if you have another retirement plan or more than 100 employees.

A Different Way To Give — Donor-Advised Funds

Are you looking for a different way to give to your favorite charities? If you are, you may want to consider a donor-advised fund.

Donor-advised funds are a popular option because they offer several attractive benefits: Relatively modest contribution guidelines, little to no set-up costs, few ongoing responsibilities, name recognition if desired, and the ability to consolidate contributions and thereby make a greater impact on chosen causes. In 2010, assets in donor-advised funds totaled nearly $30 billion, more than a 12% increase from 2009.*

Fund Basics

With a donor-advised fund, you make a contribution (or series of contributions) to the fund and recommend how you would like your gifts to be disbursed. Generally, the donor’s recommendations will be followed, but the sponsoring organization has the final say as to how the money is actually distributed.

Tax Benefits

  • As the donor, you can potentially take advantage of these tax breaks:
  • An immediate deduction that reduces your federal taxable income (subject to certain tax law limitations)
  • Avoidance of capital gains taxes on appreciated assets you donate directly to the fund
  • A reduction in the value of your estate, potentially saving future estate taxes

Do Your Research

If you are interested in setting up a donor-advised fund, do your homework. Ask the sponsoring organization what types of assets it will accept. Funds also may have minimum contribution requirements to establish a named fund. Make sure you understand what restrictions apply to grants, what fees are involved, and what services are offered to help donors. And find out whether the fund will continue in perpetuity or end when you die.

* “Donor-Advised Fund Grants Inch Up in 2010,” The Chronicle of Philanthropy, December 20, 2011

The general information in this publication is not intended to be nor should it be treated as tax, legal or accounting advice. Additional issues could exist that would affect the tax treatment of a specific transaction and, therefore, taxpayers should seek advice from an independent tax advisor based on their particular circumstances before acting on any information presented. This information is not intended to be nor can it be used by any taxpayer for the purpose of avoiding tax penalties.

Forward Thinking