7 Ways to Reduce the Alternative Minimum Tax
7 Ways to Reduce the Alternative Minimum Tax
Dr. Scott Stratton, CFP®, CFA
The Alternative Minimum Tax, or AMT, was created by Congress in 1969 after 155 wealthy taxpayers were able to use a large number of tax deductions to eliminate their tax bill entirely and pay zero federal income tax. Although the AMT originally targeted this small number of individuals, the AMT thresholds were not indexed for inflation until 2013, so the AMT today applies to a substantial number of taxpayers. While the AMT can affect some taxpayers with as little as $75,000 in income, those with $200,000 to $1,000,000 in income are the most likely to be subject to the AMT.
The AMT is a parallel tax system which requires taxpayers to calculate their taxes two ways: first under the standard tax code, and second using the AMT rules. If the AMT amount is higher, the difference is added to your tax due. Here's how the AMT is calculated.
Regular Taxable Income
+ or - AMT Adjustments
+ AMT Preference Items
- AMT Exemption
= Alternative Minimum Taxable Income
The tax rate applied is 26% of AMTI below $185,400 and 28% above $185,400 (2015).
Adjustments to AMT are deductions which are disallowed and added back to AMT Income, including:
Standard deduction, personal exemptions
Some itemized deductions and miscellaneous deductions
Property and Sales Taxes
Interest on a HELOC or HEL, if not used for home improvements; Interest on a second residence, if that residence is a boat or trailer
Exercise of an Incentive Stock Option
Other deductions, such as depreciation, investment interest, and passive losses.
AMT Preference Items are not taxable under the regular tax code, but are added to your taxable income under the AMT. They include:
Interest from private-activity municipal bonds
Intangible drilling costs
Certain types of depreciation
Traditional tax-reduction strategies often focus on increasing your itemized deductions, but since the AMT adds back many of these deductions as Adjustments, increasing your deductions may not help lower your tax bill if you are subject to the AMT.
Here are seven ways to help you reduce your taxes under the AMT:
1) Maximize Retirement Contributions. Your contributions to a 401(k), other employer retirement plan, or tax deductible IRA will lower your gross income and reduce your taxable income under both regular tax and the AMT. For 2015, the 401(k) contribution limit is $18,000, or $24,000 if age 50 or over.
Many people think they are maximizing their retirement contributions, when in fact there are additional ways for them to contribute. Some people miss the catch-up provision, which applies to the calendar year you turn 50. Even if your birthday is December 31, you can contribute $24,000 for the year. For married couples, we often see that the higher earning spouse is maximizing their contributions, but the lower earning spouse is not. Other investors miss their eligibility for a tax-deductible Traditional IRA in addition to a 401(k). For those who have self-employment income or 1099 jobs, you may be eligible for a 401(k) at your W-2 job and also fund a SEP-IRA based on your self-employment or 1099 income.
I am surprised how often tax preparers don't inform their clients of all the ways they may be eligible to make retirement contributions. Be sure to ask your tax preparer and financial planner if there are any contribution opportunities which you may have missed. And remember, you don't have to use “new” money to fund an IRA or retirement account. Moving money from an individual or joint account into an IRA will get you the tax savings and move some of your investment dollars into a tax-deferred account.
2) FSA/HSA. If your company offers a cafeteria plan, you may be eligible to pay for certain medical or child care expenses pre-tax, by using a Flexible Spending Account (FSA). If your company health plan offers a qualified High Deductible Health Plan (HDHP), you can also establish a Health Savings Account (HSA) and fund that account with pre-tax contributions.
Both the FSA and HSA contributions lower your gross income and will reduce both your regular tax and AMT. The FSA is useful if you have predictable costs each year for expenses such as medical deductibles, prescriptions, and child care. If you know you will have these expenses, you are missing out on a valuable benefit if not paying those costs with pre-tax money.
The HSA is a terrific tool for accumulating money for future health costs. You do not have to use your HSA funds this year and there is no expiration date on an HSA; you can keep those funds indefinitely and many HSAs have a wide range of investment options for long-term growth. An HSA can be used for virtually any health cost, such as office visits, deductibles, prescriptions, glasses or contacts, even to pay your Medicare premiums.
3) Switch from the Standard Deduction to Itemized. The Standard Deduction is removed entirely from the AMT, however, some Itemized Deductions may remain in place (or are reduced) under the AMT. If you originally used the Standard Deduction, re-do your return using Itemized Deductions and this can improve your net tax on the AMT side.
4) Reduce your Taxable Investment Income. While you can't do much about your salary, it is possible to lower your income taxes by reducing the taxable income thrown off by your investment portfolio. This doesn't mean you will reduce the returns on your portfolio, but rather make those gains more tax efficient. Here are a couple of steps you can take:
Harvest losses annually to offset realized capital gains. Avoid realizing short-term capital gains by keeping positions for at least one year. Large capital gains can pull a taxpayer above the AMT threshold, so it pays to be aware of your possible gains before placing trades.
Replace your actively managed funds with Exchange Traded Funds (ETFs). ETFs typically have little or no capital gains distributions, whereas funds which actively trade are required to pass on their realized gains annually. With an ETF, you often will not have any capital gains until you decide to sell the position.
Asset location. Move funds that generate ordinary income, such as bond funds or Real Estate Investment Trusts (REITs) to an IRA or other qualified account.
Consider Tax-Free municipal bonds. On an after-tax basis, municipal bonds offer attractive returns, especially for tax payers in a higher tax bracket.
If most of your portfolio is in taxable accounts, as opposed to retirement accounts, consider purchasing a low-cost annuity to hold some of your fixed income allocation. Although an annuity will not receive long-term capital gains treatment, an annuity will grow tax-deferred, which makes it an attractive location for holding fixed income investments which are taxed as ordinary income.
5) Replace Private Activity Municipal Bonds. Income from Private Activity bonds is an AMT Preference Item. This income is tax-free under the regular tax, but becomes taxable under the AMT. Private Activity Bonds are issued by a state or local government, but the proceeds are used for a private business use, such as an airport or stadium. If you own a Private Activity bond, replace it with an AMT-free bond. Bond funds often have as much as 20% of their holdings in Private Activity bonds, because these bonds may pay higher interest rates. If you have significant holdings in municipal bond funds, you may want to look for an AMT-free fund.
6) Plan your stock options carefully. Employees who receive Incentive Stock Options are often surprised to learn they may have triggered the AMT. Often, they want to hold the stock for one year before selling in order to qualify for long-term capital gains treatment on their gain. Unfortunately, under the AMT, the difference between the option's exercise price and the market price is considered taxable income for the AMT. Even if the stock subsequently drops, you still owe the AMT even though you haven't sold any shares! I've seen some real tax headaches occur which could have been avoided by getting good advice from a CPA or financial planner familiar with the rules about stock options.
7) Manage your miscellaneous itemized deductions. If your exposure to the AMT is being triggered by a one-time event (such as stock options), consider deferring some of your itemized deductions to another year. Otherwise, the value of those deductions may be lost under the AMT. For example, if you can defer paying property taxes from December to January, this will place that tax deduction in another year. If you have a large number of unreimbursed employee expenses, ask your employer if they can reimburse some of those expenses. If you are self-employed, be sure to put your business expenses on Schedule C, and not as a miscellaneous deduction. Use the home office deduction, if you are eligible. Lastly, if you can time large medical expenses, those are also deductions which would be lost under the AMT.
You may not be able to eliminate your exposure to the Alternative Minimum Tax, but if you understand which deductions are removed as adjustments and know which preference items would be added to your AMT Income, you are well on your way to minimizing your tax bill. Try to reduce your “above the line” income as much as possible, using retirement accounts, FSA, and HSA plans, because the AMT adds back many of the “below the line” deductions. Plan proactively to take these steps; you can't wait until next April and then wish you could reduce your AMT for the previous year
This information is offered for educational purposes only and is not to be construed as specific tax, legal, or investment advice. Consult with your CPA or tax professional regarding your personal tax situation and before implementing any of the strategies discussed in this article.