Although the American Taxpayer Relief Act of 2012 finally ended more than a decade of temporary AMT patches and fixes that kept expiring and needing renewals, the tax act didnt actually repeal the AMT permanently. Instead, the big tax package provided permanent relief by locking in the AMT exemptions from 2011, and adjusting the exemption and everything else under the AMT system for inflation going forward.
As a result, high-income individuals continue to face potential exposure to the AMT, depending on their income levels and on the adjustments and preference items that have to be added back to income for AMT purposes. Fortunately, though, a clients AMT exposure can be quickly evaluated by looking at a chart that details income after deductions and the amount of deductions that are lost for AMT purposes.
Its worth noting that being exposed to the AMT is not always a bad outcome, and can actually be an opportunity. Because the top AMT tax rate is 28%, high-income individuals may actually want to accelerate income into an AMT year at some point. In an AMT environment, the primary planning opportunity is to manage income around the AMT bump zone that span of income where the AMT exemption is phased out, temporarily increasing AMT rates (and capital gains rates) by an extra 7 percentage points.
For those below the AMT bump zone, the goal is to spread out income to stay below the zone. But for those above it, the best strategy to reduce the long-term bite of the AMT may actually be to pay even more in taxes, but at AMT rates.
UNDERSTANDING THE AMT
Conceptually, the AMT is a remarkably simple tax system: Add up all your income, subtract relatively few deductions, deduct one large AMT exemption to make up for all the other deductions that arent available under the AMT and then apply a tax rate of 26% on the first $175,000 and 28% on the remainder. Viewed from this perspective, the AMT is simpler than the regular tax system, as it has fewer deductions, fewer phaseouts and fewer tax brackets.
In fact, both the regular tax system and the AMT are more aligned than most realize. For instance, the 2 Tax Systems chart on page 96 shows the tax calculation for a married couple with three children, who in 2014 earned $175,000, donated $5,000 to charities, and paid $15,000 in mortgage interest on their original mortgage and another $5,000 of home equity interest for a cash-out refinance used to pay down credit cards (with the latter not deductible for AMT purposes). They also paid $9,000 in real estate taxes and $15,000 in state income taxes.
Under the regular tax system, they have $49,000 of deductions and five personal exemptions of $3,950 (a total of $19,750) for a net taxable income of $106,250, and a tax liability of $18,275 (blended across the 10%, 15% and 25% tax brackets).
Under the AMT system, the couple simply deducts their $5,000 of charitable contributions and $15,000 of acquisition mortgage interest, subtracts their $82,100 AMT exemption and finishes with net income of $72,900. At a 26% tax rate, they have a total tentative minimum tax liability under the AMT system of $18,954.
These taxpayers would owe an additional $679 of taxes because of the AMT (which brings the $18,275 tax liability up to $18,954). While the comparison itself is somewhat complex, the actual calculation of the AMT was rather simple.
In practice, however, the AMT is incredibly messy to calculate because you have to go through the entire process of calculating tax exposure under the regular system, then unwind various AMT adjustments and preference items, then reapply a new AMT exemption (to the extent not phased out) and calculate a tax liability on the amount left over.
Given that the AMT system applies only in situations that produce a greater tax liability than the regular tax system taxpayers pay based on whichever produces the larger tax bill evaluating AMT exposure involves determining whether there are enough add-backs so that, after subtracting the available AMT exemption and using the AMT rates, the taxes due under the AMT system will be greater than the existing regular tax liability.
Accordingly, by knowing clients regular taxable income after all deductions, we can also know their regular tax liability and figure out exactly what portion of their deductions would have to be AMT adjustments and preference items to trigger AMT exposure.
The Potential Exposure to AMT chart below shows the exact amount of AMT adjustments and preference items that would result in AMT exposure for 2014. For any given level of income (based on regular taxable income after all deductions), go through the list of deductions and exemptions that were claimed. If the ones that are AMT adjustments or preferences add up to something greater than the amount shown in the table, there will be some AMT exposure.
For instance, if a couples income after all deductions is $200,000, and those deductions include $20,000 of state income taxes, $8,000 of personal exemptions and $4,000 of real estate taxes, the total is $32,000, and the couple will end up paying some AMT (because $32,000 is greater than $30,048).
In its early years, AMT exposure was typically triggered by aggressive or esoteric tax shelters. Yet the AMT is now usually triggered by relatively common and mundane tax deductions; the list includes state income taxes, real estate taxes, a large number of personal exemptions and high miscellaneous itemized deductions (including advisors investment management fees).
As the chart shows, for a couple with $300,000 of taxable income after deductions, with two personal exemptions worth $7,900 (simply for being a married couple), it takes only $13,521 of additional AMT adjustments to trigger the AMT. It will be impossible for them to avoid the AMT in any state with a tax rate of more than 4.5%, as just the two exemptions and the state taxes they must pay are alone enough to trigger the AMT.
On the other hand, the tax act which brought back the so-called Pease and PEP phaseouts on itemized deductions and personal exemptions ended up reducing individual exposure to the AMT at higher income levels. Because the phaseouts effectively increased the regular income tax brackets and made the regular tax liability larger, higher-income taxpayers wind up paying more in the regular tax system, and are thus less likely to be subject to the AMT.
AMT PLANNING STRATEGIES
Under the regular tax system, tax planning is relatively straightforward:
Since tax brackets rise as income increases, the goal is to defer income when income is high, and accelerate income when income is low by harvesting it (e.g., taking capital gains or doing Roth conversions) to avoid having too much income that drive the client into higher brackets in the future.
With the AMT, though, planning is different. The system is a relatively flat tax system with only two brackets: 26% and 28%. Accelerating income isnt necessarily helpful, and deferring income isnt necessarily harmful. But theres one important nuance of the AMT system: As income rises, the large AMT exemption is itself phased out. Once the phaseout threshold is reached (at $117,300 for individuals and $156,500 for married couples, indexed annually for inflation), every additional $1 of income also phases out 25 cents of the exemption which at a 26% to 28% tax rate is actually the equivalent of a 6.5% to 7% surtax.
As a result, taxpayers who are phasing out their AMT exemption face a bump zone of tax rates, as their AMT marginal tax rate jumps up to 32.5% and then 35% before ultimately falling back to 28% once the AMT exemption is fully phased out. The Bump Zones chart on page 98 shows the zones for individuals and married couples. (Note that the end of the AMT depends on the combination of income and AMT-related deductions and may vary from one individual or couple to the next.)
MIND THE BUMP
Given that bump in marginal tax rates in the middle, AMT tax planning takes on a straightforward goal: helping clients avoid the bump to the extent possible.
If income is low, the best approach is to spread out or defer income to stay below the bump zone. But if income is high, the best approach may be to accelerate income to get out of the zone, since the top AMT rate remains capped at only 28% (and 20% + 3.8% = 23.8% for capital gains at those income levels) once the exemption is phased out, and a client who faces the zone later on could be taxed at 32.5% to 35%.
For many individuals, the best approach to an income year of, say, $500,000 is to accelerate and take more income pushing it up to $700,000 or more at a 28% AMT rate.
Notably, the AMT exemption phaseout surtax also applies to capital gains, which are still subject to the usual four brackets (including the impact of the 3.8% Medicare surtax) but are bumped even higher because of the AMT exemption phaseout. Put another way: The 15% capital gains rate still applies for AMT purposes, but may rise to 21.5% as the exemption phases out. It also means its wise to avoid capital gains in the bump zone and harvest them above the threshold.
Ultimately, those looking to accelerate income in AMT years past the bump zone should be cautious not to add too much lest they be subject to the 39.6% marginal tax rate in regular tax system rather than the 28% AMT rate. This crossover point varies, depending on just how much in excess AMT-adjusted deductions the taxpayer has, as well as his or her state tax rate.
Michael Kitces, CFP, is a partner and director of research at Pinnacle Advisory Group in Columbia, Md., publisher of the blog Nerds Eye View and a Financial Planning contributing writer. Follow him on Twitter at @MichaelKitces.